Presentation on theme: "American Style of Life [Constitution for the United States of America] We the People of the United States, in Order to form a more perfect Union, establish."— Presentation transcript:
1 American Style of Life[Constitution for the United States of America]We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.Article. I.Section. 1. All legislative Powers herein granted shall be vested in a Congress of the United States, which shall consist of a Senate and House of Representatives.Section. 2. The House of Representatives shall be composed of Members chosen every second Year by the People of the several States, and the Electors in each State shall have the Qualifications requisite for Electors of the most numerous Branch of the State Legislature.No Person shall be a Representative who shall not have attained to the Age of twenty five Years, and been seven Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State in which he shall be chosen.Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers, which shall be determined by adding to the whole Number of free Persons, including those bound to Service for a Term of Years, and excluding Indians not
2 taxed, three fifths of all other Persons [Modified by Amendment XIV] taxed, three fifths of all other Persons [Modified by Amendment XIV]. The actual Enumeration shall be made within three Years after the first Meeting of the Congress of the United States, and within every subsequent Term of ten Years, in such Manner as they shall by Law direct. The Number of Representatives shall not exceed one for every thirty Thousand, but each State shall have at Least one Representative; and until such enumeration shall be made, the State of New Hampshire shall be entitled to chuse three, Massachusetts eight, Rhode-Island and Providence Plantations one, Connecticut five, New-York six, New Jersey four, Pennsylvania eight, Delaware one, Maryland six, Virginia ten, North Carolina five, South Carolina five, and Georgia three.When vacancies happen in the Representation from any State, the Executive Authority thereof shall issue Writs of Election to fill such Vacancies.The House of Representatives shall chuse their Speaker and other Officers; and shall have the sole Power of Impeachment.Section. 3. The Senate of the United States shall be composed of two Senators from each State, chosen by the Legislature thereof [Modified by Amendment XVII], for six Years; and each Senator shall have one Vote.Immediately after they shall be assembled in Consequence of the first Election, they shall be divided as equally as may be into three Classes. The Seats of the Senators of the first Class shall be vacated at the Expiration of the second Year, of the second Class at the Expiration of the fourth Year, and of the third Class at the Expiration of the sixth Year, so that one third may be chosen every second Year; and if Vacancies happen by Resignation, or otherwise, during the Recess of the Legislature of any State, the Executive thereof may make temporary Appointments until the next Meeting of the Legislature, which shall then fill such Vacancies [Modified by Amendment XVII].No Person shall be a Senator who shall not have attained to the Age of thirty Years, and been nine Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State for which he shall be chosen.
3 The Vice President of the United States shall be President of the Senate, but shall have no Vote, unless they be equally divided.The Senate shall chuse their other Officers, and also a President pro tempore, in the Absence of the Vice President, or when he shall exercise the Office of President of the United States.The Senate shall have the sole Power to try all Impeachments. When sitting for that Purpose, they shall be on Oath or Affirmation. When the President of the United States is tried, the Chief Justice shall preside: And no Person shall be convicted without the Concurrence of two thirds of the Members present.Judgment in Cases of Impeachment s for raising Revenue shall originate in the House of Representativeshall not extend further than to removal from Office, and disqualification to hold and enjoy any Office of honor, Trust or Profit under the United States: but the Party convicted shall nevertheless be liable and subject to Indictment, Trial, Judgment and Punishment, according to Law.Section. 4. The Times, Places and Manner of holding Elections for Senators and Representatives, shall be prescribed in each State by the Legislature thereof; but the Congress may at any time by Law make or alter such Regulations, except as to the Places of chusing Senators.The Congress shall assemble at least once in every Year, and such Meeting shall be on the first Monday in December [Modified by Amendment XX], unless they shall by Law appoint a different Day.
4 Section. 5. Each House shall be the Judge of the Elections, Returns and Qualifications of its own Members, and a Majority of each shall constitute a Quorum to do Business; but a smaller Number may adjourn from day to day, and may be authorized to compel the Attendance of absent Members, in such Manner, and under such Penalties as each House may provide.Each House may determine the Rules of its Proceedings, punish its Members for disorderly Behaviour, and, with the Concurrence of two thirds, expel a Member.Each House shall keep a Journal of its Proceedings, and from time to time publish the same, excepting such Parts as may in their Judgment require Secrecy; and the Yeas and Nays of the Members of either House on any question shall, at the Desire of one fifth of those Present, be entered on the Journal.Neither House, during the Session of Congress, shall, without the Consent of the other, adjourn for more than three days, nor to any other Place than that in which the two Houses shall be sitting.Section. 6. The Senators and Representatives shall receive a Compensation for their Services, to be ascertained by Law, and paid out of the Treasury of the United States. They shall in all Cases, except Treason, Felony and Breach of the Peace, be privileged from Arrest during their Attendance at the Session of their respective Houses, and in going to and returning from the same; and for any Speech or Debate in either House, they shall not be questioned in any other Place.No Senator or Representative shall, during the Time for which he was elected, be appointed to any civil Office under the Authority of the United States, which shall have been created, or the Emoluments whereof shall have been encreased during such time; and no Person holding any Office under the United States, shall be a Member of either House during his Continuance in Office.
5 Section. 7. All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.Every Bill which shall have passed the House of Representatives and the Senate, shall, before it become a Law, be presented to the President of the United States; If he approve he shall sign it, but if not he shall return it, with his Objections to that House in which it shall have originated, who shall enter the Objections at large on their Journal, and proceed to reconsider it. If after such Reconsideration two thirds of that House shall agree to pass the Bill, it shall be sent, together with the Objections, to the other House, by which it shall likewise be reconsidered, and if approved by two thirds of that House, it shall become a Law. But in all such Cases the Votes of both Houses shall be determined by yeas and Nays, and the Names of the Persons voting for and against the Bill shall be entered on the Journal of each House respectively. If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been presented to him, the Same shall be a Law, in like Manner as if he had signed it, unless the Congress by their Adjournment prevent its Return, in which Case it shall not be a Law.Every Order, Resolution, or Vote to which the Concurrence of the Senate and House of Representatives may be necessary (except on a question of Adjournment) shall be presented to the President of the United States; and before the Same shall take Effect, shall be approved by him, or being disapproved by him, shall be repassed by two thirds of the Senate and House of Representatives, according to the Rules and Limitations prescribed in the Case of a Bill.Section. 8. The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;To borrow Money on the credit of the United States;To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes;To establish an uniform Rule of Naturalization, and uniform Laws on the subject of Bankruptcies throughout the United States;To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;
6 To provide for the Punishment of counterfeiting the Securities and current Coin of the United States;To establish Post Offices and post Roads;To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries;To constitute Tribunals inferior to the supreme Court;To define and punish Piracies and Felonies committed on the high Seas, and Offences against the Law of Nations;To declare War, grant Letters of Marque and Reprisal, and make Rules concerning Captures on Land and Water;To raise and support Armies, but no Appropriation of Money to that Use shall be for a longer Term than two Years;To provide and maintain a Navy;To make Rules for the Government and Regulation of the land and naval Forces;To provide for calling forth the Militia to execute the Laws of the Union, suppress Insurrections and repel Invasions;To provide for organizing, arming, and disciplining, the Militia, and for governing such Part of them as may be employed in the Service of the United States, reserving to the States respectively, the Appointment of the Officers, and the Authority of training the Militia according to the discipline prescribed by Congress;To exercise exclusive Legislation in all Cases whatsoever, over such District (not exceeding ten Miles square) as may, by Cession of particular States, and the Acceptance of Congress, become the Seat of the Government of the United States, and to exercise like Authority over all Places purchased by the Consent of the Legislature of the State in which the Same shall be, for the Erection of Forts, Magazines, Arsenals, dock-Yards, and other needful Buildings; — And
7 To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Powers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof.Section. 9. The Migration or Importation of such Persons as any of the States now existing shall think proper to admit, shall not be prohibited by the Congress prior to the Year one thousand eight hundred and eight, but a Tax or duty may be imposed on such Importation, not exceeding ten dollars for each Person.The Privilege of the Writ of Habeas Corpus shall not be suspended, unless when in Cases of Rebellion or Invasion the public Safety may require it.No Bill of Attainder or ex post facto Law shall be passed.No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.No Tax or Duty shall be laid on Articles exported from any State.No Preference shall be given by any Regulation of Commerce or Revenue to the Ports of one State over those of another; nor shall Vessels bound to, or from, one State, be obliged to enter, clear, or pay Duties in another.No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.No Title of Nobility shall be granted by the United States: And no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any present, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.
8 Section. 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports, except what may be absolutely necessary for executing it's inspection Laws; and the net Produce of all Duties and Imposts, laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Controul of the Congress.No State shall, without the Consent of Congress, lay any Duty of Tonnage, keep Troops, or Ships of War in time of Peace, enter into any Agreement or Compact with another State, or with a foreign Power, or engage in War, unless actually invaded, or in such imminent Danger as will not admit of delay.Article. II.Section. 1. The executive Power shall be vested in a President of the United States of America. He shall hold his Office during the Term of four Years, and, together with the Vice President, chosen for the same Term, be elected, as follows:Each State shall appoint, in such Manner as the Legislature thereof may direct, a Number of Electors, equal to the whole Number of Senators and Representatives to which the State may be entitled in the Congress: but no Senator or Representative, or Person holding an Office of Trust or Profit under the United States, shall be appointed an Elector.
9 The Electors shall meet in their respective States, and vote by Ballot for two Persons, of whom one at least shall not be an Inhabitant of the same State with themselves. And they shall make a List of all the Persons voted for, and of the Number of Votes for each; which List they shall sign and certify, and transmit sealed to the Seat of the Government of the United States, directed to the President of the Senate. The President of the Senate shall, in the Presence of the Senate and House of Representatives, open all the Certificates, and the Votes shall then be counted. The Person having the greatest Number of Votes shall be the President, if such Number be a Majority of the whole Number of Electors appointed; and if there be more than one who have such Majority, and have an equal Number of Votes, then the House of Representatives shall immediately chuse by Ballot one of them for President; and if no Person have a Majority, then from the five highest on the List the said House shall in like Manner chuse the President. But in chusing the President, the Votes shall be taken by States, the Representation from each State having one Vote; a quorum for this Purpose shall consist of a Member or Members from two thirds of the States, and a Majority of all the States shall be necessary to a Choice. In every Case, after the Choice of the President, the Person having the greatest Number of Votes of the Electors shall be the Vice President. But if there should remain two or more who have equal Votes, the Senate shall chuse from them by Ballot the Vice President [Modified by Amendment XII].The Congress may determine the Time of chusing the Electors, and the Day on which they shall give their Votes; which Day shall be the same throughout the United States.No Person except a natural born Citizen, or a Citizen of the United States, at the time of the Adoption of this Constitution, shall be eligible to the Office of President; neither shall any Person be eligible to that Office who shall not have attained to the Age of thirty five Years, and been fourteen Years a Resident within the United States.In Case of the Removal of the President from Office, or of his Death, Resignation, or Inability to discharge the Powers and Duties of the said Office, the Same shall devolve on the Vice President, and the Congress may by Law provide for the Case of Removal, Death, Resignation or Inability, both of the President and Vice President, declaring what Officer shall then act as President, and such Officer shall act accordingly, until the Disability be removed, or a President shall be elected [Modified by Amendment XXV].
10 The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be increased nor diminished during the Period for which he shall have been elected, and he shall not receive within that Period any other Emolument from the United States, or any of them.Before he enter on the Execution of his Office, he shall take the following Oath or Affirmation: — "I do solemnly swear (or affirm) that I will faithfully execute the Office of President of the United States, and will to the best of my Ability, preserve, protect and defend the Constitution of the United States."Section. 2. The President shall be Commander in Chief of the Army and Navy of the United States, and of the Militia of the several States, when called into the actual Service of the United States; he may require the Opinion, in writing, of the principal Officer in each of the executive Departments, upon any Subject relating to the Duties of their respective Offices, and he shall have Power to grant Reprieves and Pardons for Offences against the United States, except in Cases of Impeachment.He shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.The President shall have Power to fill up all Vacancies that may happen during the Recess of the Senate, by granting Commissions which shall expire at the End of their next Session.Section. 3. He shall from time to time give to the Congress Information of the State of the Union, and recommend to their Consideration such Measures as he shall judge necessary and expedient; he may, on extraordinary Occasions, convene both Houses, or either of them, and in Case of Disagreement between them, with Respect to the Time of Adjournment, he may adjourn them to such Time as he shall think proper; he shall receive Ambassadors and other public Ministers; he shall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States.Section. 4. The President, Vice President and all civil Officers of the United States, shall be removed from Office on Impeachment for, and Conviction of, Treason, Bribery, or other high Crimes and Misdemeanors.
11 Article. III.Section. 1. The judicial Power of the United States shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish. The Judges, both of the supreme and inferior Courts, shall hold their Offices during good Behaviour, and shall, at stated Times, receive for their Services a Compensation, which shall not be diminished during their Continuance in Office.Section. 2. The judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws of the United States, and Treaties made, or which shall be made, under their Authority; — to all Cases affecting Ambassadors, other public Ministers and Consuls; — to all Cases of admiralty and maritime Jurisdiction; — to Controversies to which the United States shall be a Party; — to Controversies between two or more States; — between a State and Citizens of another State [Modified by Amendment XI]; — between Citizens of different States; — between Citizens of the same State claiming Lands under Grants of different States, and between a State, or the Citizens thereof, and foreign States, Citizens or Subjects.In all Cases affecting Ambassadors, other public Ministers and Consuls, and those in which a State shall be Party, the supreme Court shall have original Jurisdiction. In all the other Cases before mentioned, the supreme Court shall have appellate Jurisdiction, both as to Law and Fact, with such Exceptions, and under such Regulations as the Congress shall make.The Trial of all Crimes, except in Cases of Impeachment, shall be by Jury; and such Trial shall be held in the State where the said Crimes shall have been committed; but when not committed within any State, the Trial shall be at such Place or Places as the Congress may by Law have directed.Section. 3. Treason against the United States shall consist only in levying War against them, or in adhering to their Enemies, giving them Aid and Comfort. No Person shall be convicted of Treason unless on the Testimony of two Witnesses to the same overt Act, or on Confession in open Court.The Congress shall have Power to declare the Punishment of Treason, but no Attainder of Treason shall work Corruption of Blood, or Forfeiture except during the Life of the Person attainted.
12 Article. IV.Section. 1. Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State. And the Congress may by general Laws prescribe the Manner in which such Acts, Records and Proceedings shall be proved, and the Effect thereof.Section. 2. The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States.A Person charged in any State with Treason, Felony, or other Crime, who shall flee from Justice, and be found in another State, shall on Demand of the executive Authority of the State from which he fled, be delivered up, to be removed to the State having Jurisdiction of the Crime.No Person held to Service or Labour in one State, under the Laws thereof, escaping into another, shall, in Consequence of any Law or Regulation therein, be discharged from such Service or Labour, but shall be delivered up on Claim of the Party to whom such Service or Labour may be due [Modified by Amendment XIII].Section. 3. New States may be admitted by the Congress into this Union; but no new State shall be formed or erected within the Jurisdiction of any other State; nor any State be formed by the Junction of two or more States, or Parts of States, without the Consent of the Legislatures of the States concerned as well as of the Congress.The Congress shall have Power to dispose of and make all needful Rules and Regulations respecting the Territory or other Property belonging to the United States; and nothing in this Constitution shall be so construed as to Prejudice any Claims of the United States, or of any particular State.Section. 4. The United States shall guarantee to every State in this Union a Republican Form of Government, and shall protect each of them against Invasion; and on Application of the Legislature, or of the Executive (when the Legislature cannot be convened), against domestic Violence.
13 Article. V.The Congress, whenever two thirds of both Houses shall deem it necessary, shall propose Amendments to this Constitution, or, on the Application of the Legislatures of two thirds of the several States, shall call a Convention for proposing Amendments, which, in either Case, shall be valid to all Intents and Purposes, as Part of this Constitution, when ratified by the Legislatures of three fourths of the several States, or by Conventions in three fourths thereof, as the one or the other Mode of Ratification may be proposed by the Congress; Provided that no Amendment which may be made prior to the Year One thousand eight hundred and eight shall in any Manner affect the first and fourth Clauses in the Ninth Section of the first Article; and that no State, without its Consent, shall be deprived of its equal Suffrage in the Senate.Article. VI.All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation.This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.The Senators and Representatives before mentioned, and the Members of the several State Legislatures, and all executive and judicial Officers, both of the United States and of the several States, shall be bound by Oath or Affirmation, to support this Constitution; but no religious Test shall ever be required as a Qualification to any Office or public Trust under the United States.Article. VII.The Ratification of the Conventions of nine States, shall be sufficient for the Establishment of this Constitution between the States so ratifying the Same.The Word, "the," being interlined between the seventh and eighth Lines of the first Page, The Word "Thirty" being partly written on an Erazure in the fifteenth Line of the first Page, The Words "is tried" being interlined between the thirty second and thirty third Lines of the first Page and the Word "the" being interlined between the forty third and forty fourth Lines of the second Page.Attest William JacksonSecretarydone in Convention by the Unanimous Consent of the States present the Seventeenth Day of September in the Year of our Lord one thousand seven hundred and Eighty seven and of the Independence of the United States of America the Twelfth In witness whereof We have hereunto subscribed our Names,
14 ECONOMICS AS RELIGIONThe most vital religion of the modern age has been economic progress. Ifeconomists have had a modest impact in actually generating this progress, oreven understanding the actual mechanisms by which it has occurred, theyhave had a large role in giving it social legitimacy.They have been the modernpriesthood of the religion of progress, interpreting its forms, refining itsmessages, and assuring the faithful that progress would continue.Withoutthe blessings of an authoritative priesthood, all kinds of opportunistic andpredatory forces are always lurking in wait in society, holding the potential toundermine the workings of the market as well as other core institutions. Bypromoting a culture of civic commitment to the market system, economistshave put the power of religion to work in fending off these newer temptationsof a modern kind of “devil.”
15 This should not be taken to suggest that professional economists have not had a great deal of useful and practical advice to give. economists have been defendingtheir professional status in society under false pretenses.The emperorof high economic theory has no clothes. Economists have been saying onething as a matter of theory and doing another as a matter of the daily practiceof economic policy—and the doing part has often yielded significant socialbenefits.If the objection might be raised that this assertion presupposes a subjectivedefinition of “benefit,” the objection would be valid. However, theconclusion that economics can be useful in the policy arena requires only aminimal agreement on a desirable outcome—that health is better than illness,for example, or that being warm in winter is better than being cold.
16 However,these practical contributions of economists for the most part did not require any great scientific apparatus.* The argument that “the marketworks”has been known for many centuries,even well before Adam Smith.Itoften amounts to little more than saying that a money system with prices forgoods and services will outperform a barter system as an arrangement fortheir exchange—something recognized by all kinds of societies and stated inmany times and places before modern “technical” economics. Historically,the greatest obstacle to the market is not a failure to understand its workings.Rather,the larger obstacles lie in two forms.First,many people have objectedto the market for moral and ethical reasons—that is to say,they had strong religious(or quasi-religious) objections of one form or another to the widescope for the expression of self-interest as found in the market. Second, theindividual pursuit of opportunistic actions such as corruption and dishonestbehavior—creating a climate in which “trust”does not exist in society—havethe potential to undermine the efficient workings of markets.
17 Beyond these practical religious functions central to the role of economic professionals in modern society, their other practical functions might be describedas engaging in the “science of common sense.” As a matter of intellectualcontent, the basic economic principles of price theory could belearned in a few days if not hours. The resistance of many students is moremoral than intellectual. If they must be exposed to many concrete examplesthat show how “the market works,” it is because there is a strong initialethical predisposition to reject the message (one that many noneconomistsnever overcome). If the private pursuit of self-interest was long seen inChristianity as a sign of the continuing presence of sin in the world—a reminderof the fallen condition of humanity since the transgression of Adamand Eve in the Garden—a blessing for a market economy has appeared tomany people as the religious equivalent of approving of the existence of sin.
18 Although the scientific content of economics is limited in its practical application, the economics profession still requires years of study of economictheory to win full acceptance among its members .Part of this can be seen asdeveloping a mastery of the religious artistry of economic progress—the capabilityof producing inspirational economic poetry in scientific language.Part of this long training period also serves to instill the ethics of economicprofessionalism involving a sense of commitment among economists to advancethe common good. A further purpose of professional training is torequire the budding economist to make a large investment of time andmoney—to offer a “hostage” that serves to “signal” his or her continuingcommitment over the long run to the norms of the profession.
19 QUANTUM MECHANICSQuantum mechanics, especially its Heisenberg principle ofindeterminacy, has been notable for the change it has broughtin the physicist's epistemological theory of the relation of theexperimenter to the object of his scientific knowledge. Perhapsthe most novel and important thesis of this book is its author'scontention that quantum mechanics has brought the concept ofpotentiality back into physical science. This makes quantumtheory as important for ontology as for epistemology.What of determinism? Again, there is no agreed-upon conventionamong physicists and philosophers of science about howthis word is to be used. It is in accord with the common-senseusage to identify it with the strongest possible causality. Let us,then, use the word "determinism" to denote only the strongertype of mechanical causation. Then I believe the careful readerwill get the following answer to his question: InNewtonian, Einsteinian and quantum mechanics, mechanical,rather than teleological, causality holds. This is why quantumphysics is called quantum mechanics, rather than quantumteleologies. But, whereas causality in Newton's and Einstein'sphysics is of the stronger type and, hence, both mechanical anddeterministic, in quantum mechanics it is of the weaker causaltype and, hence, mechanical but not deterministic. From thelatter fact it follows that if anywhere Heisenberg
20 uses the words "mechanical causality" in their stronger, deterministic meaning and the question be asked "Does mechanicalcausation in this stronger meaning hold in quantummechanics?" then the answer has to be "No,"It would be an error, therefore, if the reader, from Heisenberg'semphasis upon the presence in quantum mechanicsof something analogous to Aristotle's concept of potentiality,concluded that contemporary physics has taken us back toAristotle's physics and ontology. It would be an equal error converselyto conclude, because mechanical causation in its weakermeaning still holds in quantum mechanics, that all is the samenow in modern physics with respect to its causality and ontologyas was the case before quantum mechanics came into being.What has occurred is that in quantum theory contemporaryman has moved on beyond the classical medieval and themodern world to a new physics and philosophy which combinesconsistently some of the basic causal and ontological assumptionsof each. Here, let it be recalled, we use the word "ontological
21 to denote any experimentally verified concept of scientific theory which refers to the object of scientific knowledge rather thanmerely to the epistemological relation of the scientist as knowerto the object which he knows. Such an experimentally verifiedphilosophical synthesis of ontological potentiality with ontologicalmechanical causality, in the weaker meaning of the latterconcept, occurred when physicists found it impossible to accounttheoretically for the Compton effect and the results of experimenton black-body radiation unless they extended the concept ofprobability from its Newtonian and Einsteinian merely epistemological,theory-of-errors role in specifying when their theoryis or is not experimentally confirmed to the ontological role,specified in principle in the theory's postulates, of characterizingthe object of scientific knowledge itself.
22 When, however, the quantum numbers of the system are large, then the quantitative amountof uncertainty specified by the Heisenberg principle becomes insignificantand the probability numbers in the state-function canbe neglected. Such is the case with gross common-sense objects.At this point quantum mechanics with its basically weaker typeof causality gives rise, as a special case of itself, to Newtonianand Einsteinian mechanics with their stronger type of causalityand determinism. Consequently, for human beings consideredmerely as gross common-sense objects the stronger type of causalityholds and, hence, determinism reigns also.Nevertheless, subatomic phenomena are scientifically significantin man. To this extent, at least, that the causality governing himis of the weaker type, and he embodies both mechanical fate andpotentiality. There are scientific reasons for believing that thisoccurs even in heredity. Any reader who wants to pursue thistopic beyond the pages of this book should turn to What IsLife?
23 by Professor Erwin Schrodinger, the physicist after whom the time-equation in quantum mechanics is named. Undoubtedly,potentiality and the weaker form of causality holdalso for countless other characteristics of human beings, particularlyfor those cortical neural phenomena in man that are theepistemic correlates of directly introspected human ideas andpurposes.If the latter possibility is the case, the solution of a bafflingscientific, philosophical and even moral problem may be athand. This problem is: How is the mechanical causation, evenin its weaker form, of quantum mechanics to be reconciled withthe tdeological causation patently present in the moral, politicaland legal purposes of man and in the teleological causal determinationof his bodily behavior, in part at least, by these purposes?In short, how is the philosophy of physics expounded by Heisenberg to be reconciled with moral, politicaland legal science and philosophy?
24 Thus, teleological causality arises as a special case of the merchanical causality described by Heisenberg. Tthis will providea physical theory of the neurological correlates of introspectedideas, expressed in terms of the teleologically mechanicalcausality, thereby giving an explanation of how ideascan have a causally significant effect on the behavior of men.Likewise, it will show how the ideas and purposes of moral,political and legal man relate to thetheory of physical potentiality and mechanical causality sothoroughly described by Heisenberg.
25 TAXESTaxes are complicated. The U.S. federal tax code contains over three million words – about 6,000 pages. A casual browsing of the tax code’s table of contents offers a glimpse into the vast complexity of federal taxation. Entire sections of the tax code apply specifically to such topics as the taxation of vaccines, shipowners' mutual protection and indemnity associations, specially sweetened natural wines, and life insurance companies. Annual changes to the tax code imply that taxes will continue to become more complex even as politicians tout tax simplification. Taxes levied by other jurisdictions, such as states and cities, add further layers of complexity. Americans spend billions of hours each year working on their taxes, not to mention the costs of accountants and tax preparers.Tax policy has important economic consequences, both for the national economy and for particular groups within the economy. Tax policies are often designed with the intention of stimulating economic growth – although economists differ drastically about which policies are most effective at fostering growth. Taxes can create incentives promoting desirable behavior and disincentives for unwanted behavior. Taxation provides a means to redistribute economic resources towards those with low incomes or special needs. Taxes provide the revenue needed for critical public services such as social security, health care, national defense, and education.
26 Taxation is as much a political issue as an economic issue Taxation is as much a political issue as an economic issue. Political leaders have used tax policy to promote their agendas by initiating various tax reforms: decreasing (or increasing) tax rates, changing the definition of taxable income, creating new taxes on specific products, etc. Of course, no one particularly wants to pay taxes. Specific groups, such as small-business owners, farmers, or retired individuals, exert significant political effort to reduce their share of the tax burden. The voluminous tax code is packed with rules that benefit a certain group of taxpayers while inevitably shifting more of the burden to others. Tax policy clearly reflects the expression of power in the U.S. – those without power or favor are left paying more in taxes while others reap the benefits of lower taxes because of their political influence. Broad attempts to reform the tax system have produced dramatic and sudden shifts in tax policy, generally motivated by political factors rather than sound economic theory. For example, the top marginal federal tax bracket on individual income in the U.S. dropped precipitously from 70% to 28% during the 1980s. Tax policy has clearly been used to promote political, as well as economic, agendas.
27 The Structure of Taxation in the United States Tax ProgressivityThe overall system of taxation in the United States is progressive. By a progressive tax system, we mean that the percentage of income an individual (or household) pays in taxes tends to increase with increasing income. Not only do those with higher incomes pay more in total taxes, they pay a higher rate of taxes. For example, a person making $100,000 in a year might pay 25% of their income in taxes ($25,000 in taxes), while someone with an income of $30,000 might only pay a 10% tax rate ($3,000 in taxes).A tax system may also be regressive or proportional. A regressive tax system is one where the proportion of income paid in taxes tends to decrease as one’s income increases. A proportional tax system simply means that everyone pays the same tax rate regardless of income. A given tax system may display elements of more than one approach.
28 Reasons for Progressive Taxation The overall tax system of the United States, and in most other countries, is progressive for a number of reasons. A progressive tax embodies the concept that those with high incomes should pay more of their income in taxes because of their greater ability to pay without critical sacrifices. By paying a tax, any household must forego an equivalent amount of spending on goods, services, or investments. For a high-income household, these foregone opportunities might include a second home, an expensive vehicle, or a purchase of corporate stock. A low-income household, by comparison, might have to forego basic medical care, post-secondary education, or vehicle safety repairs. As income increases, the opportunity costs of paying taxes tend to be associated more with luxuries rather than basic necessities. The ability-to-pay principle recognizes that a flat (or regressive) tax rate would impose a larger burden, in terms of foregone necessities, on low-income households as compared to high-income households.A progressive tax system is also a way to address economic inequalities in a society. A high degree of inequality can be lessened by taxing high-income households at a relatively higher rate than low-income households. But we also need to consider who receives the benefits derived from tax revenues to fully evaluate a tax system’s impact on inequality. If the benefits of programs funded by taxation primarily accrue to low-income households while high-income households pay the majority of taxes, then the tax system effectively operates as a transfer mechanism. Increasing the progressivity of the tax system or altering the distribution of benefits allows redistribution of economic resources.
29 You should also be aware that the benefits of public expenditures are not evenly distributed throughout society.There is also an economic argument for a progressive tax system – it may yield a given level of public revenue with the least economic impact. To see why, consider how households with different levels of income would respond to a $100 tax cut. A low-income household would tend to quickly spend the entire amount on needed goods and services – injecting $100 of increased demand into the economy. By comparison, a high-income household might only spend a fraction on goods and services, choosing to save or invest a portion of the money. The money that a high-income household saves or invests does not add to the level of demand for goods and services in an economy. In economic terms, we say that the marginal propensity to consume tends to decrease as income increases. So, by collecting proportionally more taxes from high-income households we tend to maintain a higher level of effective demand and more economic activity.
30 The federal income tax is the most visible, complicated, and debated tax in the U.S. The federal income tax was established with the ratification of the 16th Amendment to the U.S. Constitution in It is levied on wages and salaries as well as income from many other sources including interest, dividends, capital gains, self-employment income, alimony, and prizes. To understand the basic workings of federal income taxes, you need to comprehend only two major issues. First, all income is not taxable – there are important differences among “total income,” “adjusted gross income,” and “taxable income.” Second, you need to know the distinction between a person’s “effective tax rate” and “marginal tax rate.”Total income is simply the sum of income an individual or couple receives from all sources. For most people, the largest portion of total income comes from wages or salaries. Many people receive investment income from three standard sources: interest, capital gains, and dividends. Self-employment income is also included in total income, along with other types of income such as alimony, farm income, and gambling winnings.The amount of federal taxes a person owes is not calculated based on total income. Instead, once total income is calculated, tax filers subtract some expenses as non-taxable. To obtain adjusted gross income (AGI), certain out-of-pocket expenses are subtracted from total income. These expenses include individual retirement account contributions, moving expenses, student loan interest, tuition, and a few other expenses. AGI is important because much of the tax data presented by the Internal Revenue Service (IRS) are sorted by AGI. However, taxes are not calculated based on AGI either. Taxable income is basically AGI less deductions and exemptions. Deductions are either standard or itemized. The standard deduction is a fixed amount excluded from taxation – in 2003 the standard deduction was $4,750 for single individuals and $9,500 for married couples. Tax filers have the option of itemizing their deductions. To itemize, a tax filer adds up certain expenses made during the year including state taxes, real estate taxes, mortgage interest, gifts to charity, and major medical expenses. If the itemized deductions exceed the standard deduction, then the itemized total is deducted instead. Exemptions are calculated based on the number of tax filers and dependents. A single tax filer with no dependent children can claim one exemption. A married couple with no children can claim two exemptions. Each dependent child counts as one more exemption. Additional exemptions are given for being age 65 or over or blind. In 2003, each exemption excluded a further $3,050 from taxation.
31 Taxable income is obtained by subtracting the deduction and exemption amounts from AGI. This is the amount a taxpayer actually pays taxes on. However, the amount of tax owed is not simply a multiple of taxable income and a single tax rate. The federal income tax system in the U.S. uses increasing marginal tax rates. This means that different tax rates apply on different portions of a person’s income. The concept can be illustrated with an example using the 2003 tax rates. For a single filer, the first $7,000 of taxable income (not total income or AGI) is taxed at a rate of 10%. Taxable income above $7,000 but less than $28,400 is taxed at a rate of 15%. Taxable income above $28,400 but less than $68,800 is taxed at a rate of 25%. Income above $68,800 is taxed at higher marginal rates – 28%, 33%, and 35%.Not all income, however, is taxed at the same marginal rates. Investment income from capital gains has generally been taxed at a lower rate than income from labor. Dividend income used to be taxed at the same marginal rate as labor income but the Jobs and Growth Act of 2003 also taxes dividends at the lower capital gains rate. While the top marginal rate on labor income in 2003 was 35%, the top rate on capital gains and dividend income was only 15%. Given that the vast majority of investment income is earned by wealthy taxpayers, the lower rates on investment income has important implications for the progressivity of the federal income tax.
32 Social Insurance Taxes Taxes for federal social insurance programs, including Social Security, Medicaid, and Medicare, are taxed separately from income. Social insurance taxes are levied on salaries and wages, as well as income from self-employment. For those employed by others, these taxes are generally deducted directly from their paycheck. These deductions commonly appear as “FICA” taxes – a reference to the Federal Insurance Contributions Act. Self-employed individuals must pay their social insurance taxes when they file their federal income tax returns.Social insurance taxes are actually two separate taxes. The first is a tax of 12.4% of wages, which is primarily used to fund Social Security. Half of this tax is deducted from an employee’s paycheck while the employer is responsible for matching this contribution. The other is a tax of 2.9% for the Medicare program. Again, the employee and employer each pay half. Thus, social insurance taxes normally amount to a 7.65% deduction from an employee’s wage (6.2% %). Self-employed individuals are responsible for paying the entire share, 15.3%, themselves.
33 There is a very important difference between these two taxes There is a very important difference between these two taxes. The Social Security tax is due only on the first $84,900 (in 2002) of income. On income above $84,900, no additional Social Security tax is paid. In other words, the maximum Social Security tax in 2002 that would be deducted from total wages is $5,264 ($84,900 × 0.062). The Medicare tax, however, is paid on all wages. Thus, the Medicare tax is truly a flat tax while the Social Security tax is a flat tax on the first $84,900 of income but then becomes a regressive tax when we consider income above this limit.Consider the impact of social insurance taxes on two individuals, one making a salary of $30,000 and another making $300,000. The typical worker would pay 7.65% on all income, or $2,295, in federal social insurance taxes. The high-income worker would pay the maximum Social Security contribution of $5,264 plus $4,350 for Medicare (1.45% of $300,000) for a total social insurance tax bill of $9,614. Note that this works out to a 3.2% overall tax rate, or less than half
34 the tax rate paid by the typical worker the tax rate paid by the typical worker. As the high-income individual pays a lower rate of taxation, we see that social insurance taxes are regressive.Federal Corporate TaxesCorporations must file federal tax forms that are in many ways similar to the forms individuals complete. Corporate taxable income is defined as total revenues minus the cost of goods sold, wages and salaries, depreciation, repairs, interest paid, and other deductions. Thus corporations, like individuals, can take advantage of many deductions to reduce their taxable income. In fact, a corporation may have so many deductions that it actually ends up paying no tax at all or even receives a rebate check from the federal government.Corporate tax rates, like personal income tax rates, are progressive and calculated on a marginal basis. In 2002, the lowest corporate tax rate, applied to profits lower than $50,000 was 15%. The highest corporate tax rate, applied to profits over $10 million was 35%. As with individuals, the effective tax rate corporations pay is lower than their marginal tax rate.
35 the tax rate paid by the typical worker the tax rate paid by the typical worker. As the high-income individual pays a lower rate of taxation, we see that social insurance taxes are regressive.Federal Corporate TaxesCorporations must file federal tax forms that are in many ways similar to the forms individuals complete. Corporate taxable income is defined as total revenues minus the cost of goods sold, wages and salaries, depreciation, repairs, interest paid, and other deductions. Thus corporations, like individuals, can take advantage of many deductions to reduce their taxable income. In fact, a corporation may have so many deductions that it actually ends up paying no tax at all or even receives a rebate check from the federal government.Corporate tax rates, like personal income tax rates, are progressive and calculated on a marginal basis. In 2002, the lowest corporate tax rate, applied to profits lower than $50,000 was 15%. The highest corporate tax rate, applied to profits over $10 million was 35%. As with individuals, the effective tax rate corporations pay is lower than their marginal tax rate.
36 Federal Excise TaxesAn excise tax is a tax on the production, sale, or use of a particular commodity. The federal government collects excise taxes from manufacturers and retailers for the production or sale of a surprising number of products including tires, telephone services, air travel, fossil fuels (including gasoline, diesel fuel, and aviation fuel), alcohol, tobacco, and firearms.Unlike a sales tax, which is evident as an addition to the selling price of a product, excise taxes are normally incorporated into the price of a product. In most cases, consumers are not directly aware of the federal excise taxes they pay. However, every time you buy gas, make a phone call, fly in a commercial plane, or buy tobacco products, you are paying a federal excise tax. For example, the federal excise tax on gasoline as of 2003 was about 18 cents per gallon.Federal excise taxes initially may appear to be an example of proportional taxation – everyone pays the same tax rate on goods subject to excise taxes. However, in practice excise taxes turn out to be regressive because lower-income households tend to spend a greater portion of their income on goods that are subject to federal excise taxes. This is particularly true for gasoline, tobacco, and alcohol products.
37 Federal Estate and Gift Taxes The vast majority of Americans will never be affected by the federal estate or gift taxes. These taxes apply only to the wealthiest Americans. The estate tax is applied to transfers of large estates to beneficiaries. Currently, estates valued at less than $1 million ($2 million for couples) are totally exempt from the tax. The top marginal estate tax rate is 55% but, as with individual and corporate taxes, the effective tax rates on estate tend to be lower. Provisions of the estate tax laws reduce the tax burden for the transfer of small businesses and farms.The estate tax exemption amount is scheduled to increase over the next several years to $3.5 million ($7 million for couples) in In 2010, the estate tax is scheduled to expire but this expiration is only temporary – under current law the estate tax would be reinstated in 2011.The transfer of large gifts is also subject to federal taxation. The estate tax and gift tax are complementary because the gift tax essentially prevents people from giving away their estate to beneficiaries tax-free while they are still alive. In 2002, gifts under $11,000 were excluded from the tax. Similar to the federal income tax, the gift tax rates are marginal and progressive, with a maximum tax rate of 50%. The gift tax is also scheduled for temporary expiration in 2010.The estate and gift taxes are the most progressive element of federal taxation, paid exclusively by those with considerable assets. The majority of estate taxes are paid by a very small number of wealthy taxpayers. In 2000 over half of estate taxes were collected from estates worth more than $5 million, about 0.15% of all estates.
38 State and Local TaxesLike the federal government, state governments also rely on tax revenues to fund public expenditures and transfer programs. Like the federal government, state governments rely on several different tax mechanisms including income taxes, excise taxes, and [[corporate tax]es. Thus, much of the above discussion applies to the tax structures in place in most states. However, there are some important differences that deserve mention.First, nearly all states (45 as of 2003) have instituted some type of general sales tax. State sales tax rates range from 2.9% (Colorado) to 7.25% (California). A few states reduce the tax rate on certain goods considered to be necessities, such as food and prescription drugs. For example, the general sales tax in Illinois is 6.25% but food and drug sales are taxed at only 1%. Other states with sales taxes exempt some necessities from taxation entirely. In most states, localities can charge a separate sales tax. While local sales taxes are generally lower than state sales taxes, there are exceptions. In New York the state sales tax is 4% but local sales taxes are often higher than 4%. Unlike income taxes, sales taxes tend to be regressive. The reason is that low-income households tend to spend a larger share of their income on taxable items than high-income households. Consider gasoline – which tends to be a declining share of total expenditures as income rises. An increase in gas taxes impacts low-income households more than high-income households. Some states, such as Idaho and Kansas, offer low-income households a tax credit on their state income taxes to compensate for their regressive state sales taxes.
39 Forty-one states levy an income tax Forty-one states levy an income tax. Most of these states have several progressive tax brackets (up to 10 rates) similar to the federal income tax. However, state income taxes tend to be much less progressive than the federal income tax. Six states have only one income tax rate, meaning that their income tax approaches a flat tax. Several more states have what is effectively a single tax rate because the top rate applies at a very low income. For example, Maryland’s top rate of 4.75% kicks in at only $3,000 of income.Another important distinction between the federal system of taxation and the taxes levied at state and local levels is use of property taxes. In fact, property taxes tend to be the largest revenue source for state and local governments. The primary property tax levied in the U.S. is a tax on real estate, including land, private residences, and commercial properties. Generally, the tax is an annual assessment calculated as a proportion of the value of the property, although the formulas used by localities differ significantly. Property taxes are commonly collected at a local level, but a share of property taxes is allocated for state purposes. Property taxes tend to be regressive, although less regressive than excise and sales taxes. The reason is that high-income households tend to have a lower proportion of their assets subjected to property taxes. While renters do not directly pay property taxes, most economists conclude that the costs of property taxes are largely passed on to renters in the form of higher rents.
40 HOW TO START A SMALL BUSINESS Small business is a placewhere you can take your dog to the office whenever you choose.” Lots of important issues — from your financial situation to your desire tocreate a needed product or provide a needed service to your ability to be ajack-of-all-trades — should influence your decision to become an entrepreneur.Being a small-business owner doesn’t mean that you have to work 70 hoursa week, make a six-figure income, or offer a unique product or service. Many successful small-business owners work at their craft 40 hoursa week or less and some work part-time at their business in addition toholding a regular job. The vast majority of small-business ownersprovide products or services quite similar to what’s already in the marketplaceand make reasonable but not extraordinary sums of money — and, thankslargely to the independence that small-business ownership offers, areperfectly happy doing soThe basics of doing business are the same, no matter what size thebusiness is:✓ Sales: Boeing manufactures and sells airplanes; you sell lemonade. Asale is a sale no matter what the product or service is or how large orsmall the ticket price is.✓ Cost of goods: Boeing buys parts for its vendors and suppliers; you buylemons, sugar, and paper cups from the grocery store.✓ Expenses: Boeing has employee wages and pension plans (or employeebenefits); you have sign-making costs and bubble-gumexpenditures to keep your employees happy (also a form of employeebenefits).
41 ✓ Profit: Profit is what’s left over after Boeing subtracts the cost of its goods and expenses from its sales; the same is true for your lemonadestand.Financial basics: The samewhether you’re big or smallNot only are the concepts of Business 101 — sales, cost of goods, expenses,and profit — the same for all businesses, regardless of size or productoffering, but many associated financial basics are the same, too. Here’s whatis meant:✓ Accounts payable: Boeing owes money to its vendors who provide itwith parts; you owe money to your local grocery store for supplies.✓ Accounts receivable: Boeing has money due from its customers (majorairlines and governments) that buy the company’s airplanes. You havemoney due to you from Mrs. Huxtable, who wandered by thirsty withouther purse.✓ Cash flow: Boeing has money coming in and going out through varioustransactions with customers and vendors (sometimes cash flowspositively, sometimes negatively), and so do you.✓ Assets: Boeing has its manufacturing plants and equipment, inventory,office buildings, and the like; you have your lemonade stand andcash box.✓ Liabilities: Boeing owes suppliers money; you owe money to your localgrocery store.✓ Net worth: Net worth is what’s left over after Boeing subtracts what itowes (its liabilities) from what it owns (its assets). Ditto for yoursmall-business enterprise.
42 The Small Business Administration defines small business as any business with fewerthan 500 employees. This seems a bitlarge. Consider this: With 200employees, you have, say, 400 dependents,maybe 1,000 customers, and 100 or so of thebusiness’s vendors all depending on you,trusting in you, and waiting for the mail todeliver their next check. That certainly isn’tsmall by most people's standards — not if you measuresize in terms of responsibility anyway.For those of you who like to work with numbers,our definition of small business is any businesswith 100 employees or fewer, a categorythat includes more than 98 percent of all U.S.businesses.The latest year’s U.S. government figures showthat the country is home to 27 million smallbusinesses. Of those, approximately 21 millionhave no employees. Meanwhile, hundreds ofthousands of new businesses open their doorseach year.
43 This kind of growth is an indicator of the appeal of owning a small business. (Ormaybe it’s an indicator of the lack of appeal ofworking for someone else.)Not only do small businesses createopportunities for their owners, but they alsocreate jobs. In fact, small firms create aboutthree-quarters of the new jobs in the UnitedStates.What all these numbers mean is that smallbusiness isn’t really small — it’s large, diverse,and growing. Not only is small business not smallwhen speaking in terms of the sheer numbers ofsmall businesses and their employees, it’s alsonot small when talking about the tenacity andknowledge required to start and run a smallbusiness.
44 Answering the questions After reading each question, write your response from 1 to 5 on a separatesheet of paper.1. In the games that you play, do you play harder when you fall behind, ordo you have a tendency to fold your cards and cut your losses?(5 if you play harder, 1 if you wilt under pressure)2. When you go to a sports event or concert, do you try to figure out thepromoter’s or the owner’s gross revenues? (5 if you often do, 1 if younever do)3. When things take a serious turn for the worse, is your first impulse to lookfor someone to blame, or is it to look for alternatives and solutions? (5 ifyou look for alternatives and solutions, 1 if you look for someone to blame)4. Using your friends and/or coworkers as a barometer, how would yourate your energy level? (5 if it is high, 1 if it is low)5. Do you daydream about business opportunities while commuting towork, flying on an airplane, waiting in the doctor’s office, or during otherquiet times? (5 if you often do, 1 if you never do)6. Look back on the significant changes you’ve made in your life — schools,jobs, relocations, relationships: Have you fretted and worried about thosechanges and not acted, or have you looked forward to them with excitementand been able to make those tough decisions after doing someresearch? (5 if you’ve looked forward to the decisions and tackled themafter doing your homework, 1 if you’ve been overwhelmed with worryabout the change and paralyzed from action for too long)7. Is your first consideration of any opportunity always the upside or is italways the downside? (5 if you always see the upside and recognize therisks, 1 if you dwell on the downside to the exclusion of considering thebenefits)
45 8. Are you happiest when you’re busy or when you have nothing to do? (5 if you’re always happiest when busy, 1 if you’re always happiest whenyou have nothing to do)9. As an older child or young adult, did you often have a job or a schemeor an idea to make money? (5 if always, 1 if never)10. Did you work part-time or summer jobs as a youth, or did you not workand primarily recreate/enjoy a total break over the summer?(5 if you often worked, 1 if you never did)11. Did your parents own a small business? (5 if they worked many yearsowning small businesses, 1 if they never did)12. Have you worked for a small business for more than one year?(5 if you have, 1 if you haven’t)13. Do you like being in charge and in control? (5 if you really crave thosetwo situations, 1 if you detest them)14. How comfortable are you with borrowing money to finance aninvestment, such as buying a home or an automobile? (5 if owing moneyis not a problem, 1 if it’s a huge problem)15. How creative are you? (5 if extremely creative, 1 if not creative at all)16. Do you have to balance your checkbook to the penny or is “close” goodenough? (5 if “close” is good enough, 1 if to the penny)17. When you fail at a project or task, does it scar you forever or does itinspire you to do it better the next time? (5 if it inspires you for the nexttime, 1 if it scars you forever)18. When you truly believe in something, whether it’s an idea, a product, or aservice, are you able to sell it to someone? (5 if almost always, 1 if never)19. In your current social and business environment, are you most often afollower or a leader? (5 if almost always a leader, 1 if always a follower)20. How good are you at achieving/keeping your New Year’s resolutions? (5if you almost always achieve/keep them, 1 if you never do)
46 Scoring the testNow total your score. Here’s how to assess your total:80 to 100: Go for it. If you read this book and continue to show a willingnessto be a sponge, you should succeed!60 to 79: You probably have what it takes to successfully run your ownbusiness, but take some time to look back over the questions you scoredthe lowest on and see whether you can discern any trends.40 to 59: Too close to call. Review the questions on which you scoredlow and don’t scrimp on learning more to tilt the scales in your favor.20 to 39: We could be wrong, but you’re probably better off working forsomeone else or pursuing one of the other alternatives to starting yourown business.Analyzing your resultsThe truth about a subjective test such as this one is that it can serve as ahelpful indicator, but it won’t provide you with a definitive answer. The Small-Business Owner’s Aptitude Test is, ineffect, a measure of the way you have acted in the past and not necessarilyhow you will perform in the future.Your future as a small-business owner will hold many surprises.Theskills and traits that you need to cope with those surprises will ultimatelydetermine whether your choice to start or buy a small business is the rightone. What exactly are those skills?✓ Numbers skills: These skills include those related to borrowing money,accounting for it, and reporting on the financial performance of yourcompany.✓ Sales skills: As a small-business owner, you’re always trying to sell yourproducts to someone — be it your customers, employees, or vendors.✓ Marketing skills: All small-business owners have to market theirproducts or services — no one is exempt.✓ Leadership skills: The small-business owner is the Grand Poobah of hisventure. Grand Poobahs are only as good as the manner in which thebusiness’s employees are led.
47 Does this mean that if you don’t have these skills, you should remain on the receiving end of a paycheck? Thankfully, it does not.Many successful entrepreneurs who have come before you made it withoutbeing able to personally perform all the skills necessary to run a business.So, over the course of your career, you’ll have to eitherdevelop these skills or involve someone in the business who already has them(a partner, a key employee, or a hired advisor or consultant, for example).Skills aside, successful entrepreneurs also need to have or adopt severalrequired traits:✓ Confidence: Small-business owners have to be able to coexist with riskand possibly debt. Capitalism offers its participants no guarantees; thus,the small business and consequently its owner are almost always at riskand sometimes in debt. Yet, the owner still has to sleep at night.✓ Intuition: Call it intuition or call it gut instinct, the small-business ownerhas to call things right more often than wrong, or he’ll soon be calling itquits.✓ Optimism: Successful small-business owners often see good fortune, notmisfortune; upsides, not downsides; and opportunities, not problems.The small-business owner can always hire a devil’s advocate (that’swhat lawyers and accountants are for), but the enthusiasm and optimismnecessary to drive the vision must come from the entrepreneur.✓ Drive: Successful small-business owners are driven to create a product,service a customer, and build a successful business. Similar to thecraving for chocolate, this drive doesn’t go away.✓ Passion: An entrepreneur’s passion is infectious. Your employees, yourvendors, and your customers — everyone you come in contact with —should feel your passion and feed off it.If you don’t have all five of these traits, should you resign yourself to alwaysbeing an employee? In answering this question, you first need to recognize thatbeing a good employee today also requires some of these traits, so owning abusiness isn’t your only option. Then you need to come to terms with the factthat if you don’t have most of these traits in healthy supply, you’re probablybetter off as an employee rather than a small-business owner.
48 The reasons to ownThere may be many reasons to give your boss the heave-ho. In this section,though, the best reasons are given for why people should choose to own a business:✓ The satisfaction of creation: Have you ever experienced the prideof building a chair, preparing a gourmet meal, or repairing a vacuumcleaner? Or how about providing a needed counseling service that helpspeople solve their vexing financial problems? The small-business ownergets to experience the thrill of creation on a daily basis, not to mentionthe satisfaction of solving a customer’s problem.✓ Establishment of their own culture: No more standing around the watercooler complaining about “the way things are around here.” After youstart your own business, the way things are around here is a directfunction of the way you intend them to be.✓ Financial upside: Consider Charles Schwab and Oprah Winfrey. It’s nosurprise that these one-time small-business owners are among the nation’swealthiest individuals. (A recent Small Business Administration study concludeddefinitively that although small-business ownership is risky, smallbusinessowners had a significantly higher probability of being classified ashigh income and high wealth than their employed counterparts.)✓ Self-sufficiency: For many people, working for someone else has provento be a less-than-gratifying experience. As a result of such unfulfillingexperiences, some people have discovered that if they want to providefor themselves and their families, they’d better create the opportunitythemselves. It’s either that or be willing to occasionally spend a longwait in the unemployment line.✓ Flexibility: Perhaps you prefer to work in the evenings because that’swhen your spouse works or you want to spend more time with the kidsduring the day. Or you may prefer taking frequent three-day-weekend jauntsrather than a few full-week vacations every year. As a small-business owner,despite the long hours you work, you should have more control over yourschedule. After all, you’re the boss, and you can usually tailor yourschedule to meet your personal needs, as well as those of your customers.✓ Special perks: Small-business owners have several advantages over thetypical employee. For example, small-business owners can sock awaytens of thousands of dollars into their retirement accounts per year freeof federal and state income taxes. And yes, similar to those corporateexecs who wine and dine their clients and then write off the expenses,small-business owners also have the option of writing off such costs aslong as they adhere to IRS rules.
49 The reasons not to ownIn light of the resounding potential benefits, why would any reasonable soulelect to continue receiving a paycheck? Why wouldn’t everyone want to owna business? Let us count the nays:✓ Responsibility: When you’re a small-business owner, not only does yourfamily depend on your business success, but so do your partners,your employees and their families, your customers, and sometimes yourvendors. As much as we love our small businesses, every now and theneven the most enthusiastic small-business owners wax nostalgic for thegood old days when they would punch their time card and leisurely walkout the door — really, truly, done for the day.If you’re the type of person who sometimes takes on more responsibilitythan you can handle and works too many hours, beware that anotherdrawback of running your own business is that you may be prone tobecoming a workaholic.✓ Competition: Although some people thrive on competition, that samecompetition comes back to haunt you by threatening your security.You soon find out that a host of hungry competitors is pursuing yourcustomers and threatening your livelihood, whether by cutting pricesor offering a more complete package of unique services. Sure, competitionis what makes capitalism go ’round, but you need to remember that inorder to have a competition, someone’s going to win and someone’sgoing to lose. That someone could be you.✓ Change: Products and services come, and products and services go.Nothing is sacred in the business of doing business, and the pace ofchange today is significantly faster than it was a generation ago — and itshows no signs of slowing down. If you don’t enjoy change and thecommotion it causes, then perhaps the stability that a larger, morebureaucratic organization provides is best for you.✓ Chance: Interest rates, the economy, theft, fire, natural disasters,sickness, pestilence — the list goes on. Any of these random events cansend your business reeling.✓ Red tape: Taxes, health-care reform, bureaucracy, tariffs, duties, treaties,OSHA, FDA, NAFTA, glurg, glurg, glurg.✓ Business failure: Finally, as if this list of a small business’s enemiesisn’t long enough, the owner faces the specter of the ultimate downside:business failure in the form of bankruptcy. This is the stage where theowner stands back and watches the creditors swoop in like vultures todevour his remaining business — and sometimes personal — assets.bn
50 Ask yourself this important and (we hope) revealing question: “How many businesses have I purchased in my lifetime?” If you’re like mostpeople we know, the answer is a big, fat zero.Now, you’re an intelligent and discerning person, we firmly believethat, when buying a business, you’ll benefit from retaining the services ofexperts with extensive small-business deal-making experience.Negotiating is a skill that improves with experience. Experienced advisorscan help you inspect the business you’re buying and look for red flags in thecompany’s financial statements. Advisors can also help structure the purchaseto protect what you’re buying and to gain maximum tax benefits. Toget the best deal, you need to do a number of things well, the first of which isto put a realistic and accurate value on the business you intend to buy. Thisis where we'll start and then move on to cover how to decide on the purchaseprice, how to do due diligence, and how to start off strong afteryou become the owner.
51 Valuing the BusinessWhen you begin exploring businesses for sale, you don’t know exactly what agiven business is worth and you risk overpaying for that business if you jumpinto a deal too soon. However, with time and the right resources, combinedwith a little investigative work, you can get a good handle on a particularbusiness’s worth, which may or may not be close to the owner’s asking price.You can start by taking a cue from smart home buyers and real estate investors:To find out how much a property is really worth, consider comparablesales — that is, the amounts that similar properties have sold for. Comparedto business buyers, however, home buyers have it relatively easy. Real estatetransactions are a matter of public record; small-business sales aren’t. So youhave to do some extra sleuthing to find the specific price and terms of comparablebusinesses that have sold.In the end, however, after you’ve done the math and developed a dollar valuefor the business, remember one thing: Similar to buying a house, the realworth of a business is what you, or someone else, will pay for it. A businessisn’t a car with a factory sticker price; it’s a multidimensional, complicatedorganization of people, assets, and systems. Its true value is in the eyes of thebeholder, and the beholder is you.The following sections walk you through the process of valuing a business.You won’t have to go through every step (especially if you hire a businessbroker to manage the process for you), but each one is a viable option toconsider.
52 Exploring valuing methods: Multiple of earnings and book valueMany methods exist for valuing a business. Some are unnecessarily complicated;others won’t provide you with sensible answers. For example, someadvisors and business brokers advocate using a multiple of revenue to determinethe value of a business — that is, if a business has $300,000 in revenues,it may be valued at $450,000 (a multiple of 1.5 times revenue). However, revenueis a poor proxy for profitability. Two businesses in the same field canhave identical revenue yet quite different profitability due to the efficiency oftheir operations, the pricing of their products and services, and the types ofcustomers they attract. Also, the multiple of revenue that a business may beworth varies depending on what industry the business is in. For example, themultiple for a manufacturing business is higher than the multiple for a retailestablishment or a restaurant.
53 Other measures are more exact Other measures are more exact. Here are some preferred valuation measuresfor small businesses:✓ Multiple of earnings: When you compare the sales data for comparablecompanies to the sales data for the one you’re interested in buying,determine what multiple of earnings these businesses sold for. Dividethe price the business sold for by its annual pre-tax earnings (profits) toarrive at the multiple of earnings (also known as the price-earnings ratio)of that transaction.When the multiple is low, say 3 to 1 (for example, if the business hadearnings of $50,000 and a selling price of $150,000), the buyer andseller don’t have great expectations for the business’s future earnings.However, when the multiple is high, say 12 to 1 (if the business had earningsof $50,000 and a selling price of $600,000), the buyer’s and seller’sexpectations of future earnings are correspondingly high.Future earnings are what will provide the return on the buyer’s investment;therefore, the higher the buyer expects those potential earningsto be, the more he or she is willing to pay for the business. (In general, abusiness should be able to pay for itself in three to five years. If the timeperiod is any longer than that, you’re probably paying too much for thecompany.)Small, privately held businesses typically sell for lower multiples of earningsthan larger companies in the same line of business. The reason:Small companies are less established and are riskier from an investingstandpoint. Plus, your investment in their stock will be illiquid (that is,even in good times, the stock generally can’t be converted into cashwithin a reasonable period of time).
54 ✓ Book value: In addition to looking at the sales price of other businesses relative to earnings, you can consider the value of a company’s assets.The book value of a company is the company’s assets minus its liabilities,which is the same as the net worth of the business as stated on itsbalance sheet. (We’re assuming here that the values for the assets andliabilities on the balance sheet are accurate.) The figures that go into determining book value shouldbe checked carefully to ensure that the underlying asset values andliability accounts are correct.Of these two approaches, each of which has advantages as well as imperfections,the multiple-of-earnings approach is generally considered to be farsuperior to the book-value method. After all, what you’re purchasing whenyou buy a business isn’t primarily its assets but rather its ability to generateprofits (earnings), using those assets. Some businesses, such as consultingfirms, have little in the way of tangible assets — the personnel may be thefirm’s greatest asset, and valuing that is difficult. Because the determinationof a price-earnings multiple figure is based on an income-generating formula,it’s generally a better indicator than the book-value approach, which simplymeasures the difference between assets and liabilities
55 Keep in mind that the figure you come up with when using the multiple-ofearnings approach represents the goodwill portion of the business only anddoesn’t include the value of the business’s assets. (Goodwill is, in essence, thevalue of the business’s reputation and existing customer list.) Thus, you haveto add the value of the assets to the goodwill number. The assets involved in atypical small-business purchase include accounts receivable (make sure thatthey’re all collectable), inventory (make sure that what you’re buying is merchantable),and equipment, furniture, and fixtures (the fair market valuethereof).Getting a professional appraisalBusiness appraisers make a living out of estimating the value of businesses.If you want to buy a business and your initial investigation suggests that theseller is committed and serious about selling the business, consider hiringan appraiser. Although the fees professional appraisers charge vary dependingon the size and complexity of the prospective business, you can usuallyexpect to pay somewhere north of $5,000 for the typical small business.Tax advisors, lawyers, and business consultants who specialize in workingwith small businesses may be able to refer you to a good business appraiserif they can’t do the appraisal themselves. The Institute of Business Appraisers(www.instbusapp.org; ) can provide you with a list of associationmembers in your area. Also, check the business-to-business Yellow Pagesin your area under “Appraisers — Business.”Tracking businesses you’veexplored that have soldIf your search for a business to buy lasts months or perhaps years, keeptrack of similar businesses you’ve considered that eventually sell. Thesesales provide valuable comparables because you’ve seen the businesses upclose and have obtained details about their financial position that give youperspective in assessing the sales.Obtaining the final selling price of a small business can be challenging. Youcan try asking the ex-owner, or you can speak with advisors or business brokerswho are involved in such deals.
56 Tapping the knowledge of advisors who work with similar companiesBusiness consultants, attorneys, and tax advisors you work with can assistyou with pinning down sales data for companies comparable to the oneyou’re considering buying. The key is to find advisors who have knowledgeof, and experience with, both small businesses in general and businessessimilar to the one you’re thinking of buying.If you end up buying a small business, you’ll benefit from having competentadvisors on your team who have worked on comparable deals. But before youhire an advisor for tax, legal, or business advice, be sure to check references.Also ask the advisor for a comprehensive list of business deals (including thepurchase or sale price and the industry) that he has been involved in over thepast year.Don’t be deterred by the cost of such advisors, especially tax advisors andattorneys. The terms you agree to in the purchase of a business will be withyou for a long, long time.Consulting research firms and publicationsFinding the details on similar companies that have sold can be difficult.Wouldn’t it be helpful if a service compiled such information for you? Well,you’ll be happy to know that some companies do publish comparable salesinformation or conduct company searches for a fee.One such company, BIZCOMPS, releases an annual publication that providessales price, revenue, and other financial details for businesses sold. Thiscompendium of sales information is available for different major regionsand industries in the United States (Western, Eastern, Industrial, and FoodService). Visit or call for a sample of thispublication. Each directory sells for $165. The company also offers onlineaccess to business sales data through an annual membership fee (whichvaries).Turning to trade publicationsTrade publications can help you find out more about a particular industry, aswell as how to value companies within that industry. Most publications arewilling to send you past articles on a topic, typically for a small fee. Or youmay be able to access articles from the publication’s website.
57 Enlisting the services of a business broker If you’re already working with a business broker (a salesperson who listssmall businesses for sale and who works with buyers as well) or looking at abusiness listed for sale through a business broker, the broker should be ableto provide a comparable market analysis of similar businesses that the broker’soffice has sold.Don’t put too much weight on a business broker’s analysis. Unfortunately,a broker’s “analysis” may be less analytic and more sales oriented than youwant. After all, business brokers earn commissions based on a percentage ofthe selling price of the business that you may buy through them. (The commissionsgenerally range from 6 to 10 percent, depending on the size andcomplexity of the deal.) Also, understand that business brokers generallyhave access to sales data only on the small number of similar businesses thattheir particular office has sold. Unlike real estate agents, business brokerswho work for different brokerage firms in a given community don’t share theirsales data with one another.Before enlisting the services of a broker, be sure to check her references carefully— especially given the fact that business brokers are in a virtually unregulatedindustry that requires no specific credentials or educational training toenter. Be sure to involve your own attorney when the closing comes around.Having your own attorney takes the broker’s bias out of the equation andhelps ensure that what you get is best for you. You can generally depend onyour attorney to represent your best interests; the same cannot be said aboutyour business broker.
58 Developing Purchase Offer Contingencies When you make an offer to buy a home, you generally make your purchaseoffer contingent upon (dependent on) obtaining mortgage loan approval, satisfactoryinspections, and proof that the property seller holds a clear title tothe home. When you make an offer to buy a business, you need to make yourpurchase contingent upon similar issues, including the following:✓ Inspections and due diligence: Your purchase offer for a businessshould be contingent upon a thorough review of the company’s financialstatements and interviews of key employees, customers, and suppliers(this overall evaluation is called due diligence). You should be allowedto employ whomever you like to help you with your evaluation. The typicalperiod of time allowed for due diligence is 30 to 60 days, more if thebusiness is large.
59 ✓ Financing: Unless you’re paying cash for the full purchase price of the business (which would be unusual), another condition of your purchaseoffer may be an acceptable seller-provided loan. Sellers can be a greatfinancing source, and many are willing to lend you money to purchasetheir business. Seller financing is quite common in small-business purchases;in fact, about 90 percent of all small-business sales include sellerfinancing. Yes, occasionally partial financing for a business purchasecan come from traditional lending sources (banks, relatives, friends,angel investors, and so on), but the seller is always your number oneopportunity. Think about it: If your seller still has “skin in the game,”he’s that much more motivated for you to succeed, which means he’ll bethat much more likely to help you through the transition period.Be sure to compare the terms that the seller is offering to those of somelocal banks that specialize in small-business loans. In the purchase offer, specify the acceptable loanterms, including the duration of the loan and the maximum interest rate.If interest rates jump before your loan is finalized, you don’t want to beforced to complete your deal at too high of an interest rate.✓ Noncompete clause: You don’t want to buy a business only to have theformer owner set up an identical one down the block and steal his previouscustomers from you. To avoid this unpleasant possibility, be surethat your purchase offer includes a noncompete clause that states thatthe seller can’t establish a similar business within a certain nearby geographicarea for a minimum number of years — or something like that.You may consider asking the owner, as part of the purchase deal, tomake himself available to consult with you, at a specified hourly rate,for 6 to 12 months to make sure that you tap all his valuable experience,as well as to transition relationships with key employees, vendors, andcustomers. To further align the selling owner’s interests with yours,consider having a portion of the total purchase price dependent on thefuture success of the company.If the transaction includes seller financing, most sophisticated sellerswant to continue to work with you for a period following the sale to helpyou get off on the right foot. Beware of those who don’t want to hangaround.✓ Limited potential liabilities: When you buy a business, you buy that business’sassets and usually (but not always) its liabilities. Some potentialliabilities don’t show up on a company’s balance sheet and could becomea thorn in your side. Make sure that the seller is liable for environmentalcleanup and other undisclosed existing liabilities (debts). Conduct legalsearches for liens, litigation, and tax problems. (Your attorney shouldconduct these searches for you as a part of the closing process.)
60 Allocating the Purchase Price When you pay $300,000 for a business, you’re not simply paying $300,000 forthe business. You’re paying, for example, $60,000 for the inventory, $40,000for the accounts receivable, $50,000 for the company equipment, $100,000 forgoodwill, and so on.No matter how you determine the purchase price, you must always breakdown that price, or allocate it, among the assets of the business and othercategories. This requirement applies whether you set the price of the businessby determining the value of its assets (such as through the multiple-ofearningsmethod) or by using someother method. Although allocating assets may cause your eyes to glaze over,snap to attention when the subject comes up, because how you structure thepurchase can save you tens of thousands of dollars in taxes.Experienced tax advisors will tell you that you generally want to allocatemuch of the purchase price to specific assets of the business. Some assetsare what their numbers make them out to be (such as accounts receivable),while others can be negotiable (such as equipment and goodwill). The reasonfor the negotiation is that different assets can be written off (or depreciated)over different periods of time. For instance, equipment can be depreciatedover as little as 4 years, while goodwill takes 15 years to depreciate.You must report the purchase of the business and the allocation of thepurchase price among business assets on IRS Form 8594 (Asset AcquisitionStatement). Make sure that you do so, because if you don’t, the penalty isstiff — up to 10 percent of the amount not reported.Doing Due DiligenceAfter spending months searching for the right business to buy and findingone that fits your fancy, you may well spend weeks negotiating an acceptabledeal. Just as you’re about to stumble across what you think is the finish line,you realize you have plenty more work left to go.After all, now is the time to get out the microscope and really nitpick. Beforeyou go through with the deal and fork over the dough, you have one lastchance to discover any hidden problems that exist within the business youhope to buy. Of course, all businesses have their warts, but better for you touncover them now so that the purchase price and terms reflect those warts
61 The process of thoroughly investigating your prospective business is called due diligence. During due diligence, you need to answer important questionslike these:✓ Is the business as profitable as the financial statements indicate?✓ Will the business’s customers remain after a change in ownership?✓ What lease, debt, or other obligations will you be assuming when youbuy the business?Due diligence typically lasts for 30 to 60 days, depending on the complexityof the company you’re hoping to purchase.The same experts you’re working with to put together a good deal for yoursmall-business purchase will form your due-diligence team.Think about income statement issuesThe profitability of the business is probably the single most important aspectyou need to consider during due diligence. To help you deal with incomestatement concerns, you should take the following steps:✓ Have an experienced small-business tax advisor review the company’sfinancial statements. She’ll know what to look out for. Just be sure toagree on a budget for the cost of the advisor’s services (and, therefore,the time she will spend) upfront.✓ Adjust for one-time events. If necessary, factor out one-time impactfulevents from the profit analysis. For example, if the business got anunusually large order last year that is unlikely to be repeated, subtractthe amount of that order from the profitability analysis.✓ Check the owner’s compensation. Examine the owner’s salary to seewhether it’s too high or low for the industry the business is in. Ownerscan pump up the profitability of their company in the years before theysell by reducing or keeping their salary to a minimum or by payingfamily members in the business less than fair-market salaries.
62 ✓ Consider how the building expense will change. Consider whether the rent or mortgage expense will be different after you buy the business.Any large change in that cost will clearly affect the profitability of thebusiness.✓ Factor in financing expenses. Be sure to calculate what will happen toprofits when you factor in the financing costs from borrowing money tobuy the business.✓ Pay attention to trends. How are the sales and the profits trending?If this year’s profits were, say, $80,000 and last year’s were $100,000,the trend is unfavorable. On the other hand, if this year’s profits were$70,000 and last year’s were $50,000, you’re looking at a good trend.Knowledgable buyers are generally willing to pay a higher multiple forfavorable trends.Consider legal and tax concernsBefore you make a deal, follow these steps to research any legal or tax issuesthe business may have:✓ Look for liens. Check to make sure that no liens are filed against assetsof the business and, if you’re buying real estate, that the property titleis clear. A competent attorney can help with this tedious and importantlegal task.✓ Get proof that all taxes are paid. Get the seller to provide proof, certifyingthat federal and state employment, sales, and use taxes are all paid up.Moving Into Your BusinessIf you’ve made it through the searching, researching, negotiating, and closingphases, you’re now a bona fide small-business owner. Congratulations andwelcome to your new business! You’ve completed a lot of challenging andimportant work and should feel proud of yourself.After your deal is closed, be sure to take care of the following tasks as soon aspossible:✓ Disclose ownership transfer. Notify creditors of the transfer of ownership.In the counties where the company does business, publish atransfer-of-ownership notice in a general circulation newspaper. If youomit this step, you risk having unsecured creditors come after yourbusiness for outstanding debts that the previous owner had.
63 ✓ Write a business plan and mission statement or refine your plan if you’ve already started it. If you researched the industry and evaluatedin detail the business you bought, you should be able to generate a goodbusiness plan, including an applicable mission statement, without toomuch hassle. Although completing your business plan will take sometime and thinking, doing so early on in the process will benefit you andyour business in increased sales, reduced costs, and happier employees.If you ever intend to seek outside capital from a banker or investor,you’ll need a good business plan. Note: An ideal time to beginwork on this business plan is during the due-diligence phase.✓ Plan the company’s finances. Going forward, you need to have a firmhandle on the revenue, expenses, and cash flow of your business. Forexample, you need to set up a budget for your business and forecastfuture needs for capital, both of which should be included in the businessplan.✓ Consider the entity/legal form of organization. Just because the businessyou bought was structured as a sole proprietorship or corporationdoesn’t mean that legal entity makes the most sense for you. Your attorney and tax advisor should be part of this decision.✓ Spend time understanding your customers. Get to know your best customersas soon as the ink is dry on the sales agreement. Without goodcustomers who buy profitable products and services and who pay theirbills on time, you don’t have a viable long-term business. Even the bestbusiness is bound to lose customers for a variety of reasons beyondthe business owner’s control. So don’t skimp on understanding yourcustomers’ needs, particularly what makes them buy your company’swares and what their ongoing customer service needs are. Completingyour business plan can help you clarify many of these vital issues. Plus, you can get a feel for how to market your productsand services to customers and how to keep your customers loyal.✓ Get to know your employees. Employees who liked the previousowner(s) will take time to warm up to you. Some employees may fear fortheir jobs or worry that a change in ownership will lead to reduced jobsatisfaction. Err on the side of doing more listening to your employeesrather than always being the one jabbering about all your grand plans.The employees contain a wealth of knowledge about the business fromwhich you can learn, and the better you listen, the more the employeeswill grow to respect and like you.
64 structure (see Chapters 16 and 17). Don’t make rash changes in this area, especially if you’re thinking about reducing benefits and/orcompensation. Early, negative changes can have ugly long-termconsequences.✓ Walk; don’t run. Don’t make huge changes your first day, week, or evenmonth at the helm. Take your time to discover the culture of the business,the needs of its customers, and the idiosyncrasies of its vendorsbefore you attempt to make major changes. Employees, customers, andvendors don’t like quick change, especially when the person behind thechange is new and relatively unknown.✓ Consult the prior owner. Don’t expect to know everything there is toknow about running your new business. No matter how much better abusiness manager you may think you are than your predecessor, he orshe has certain knowledge and skills that you don’t have. Don’t let yourego stand in the way of asking the previous owner for advice.✓ Work with a good tax advisor. You don’t want to fall behind in filingyour taxes or filling out the right tax forms, or you’ll have a nasty surprisein the form of an unexpectedly large tax bill. The tax advisor whohelped you with evaluating your business purchase may be able to recommenda tax advisor you can work with at least during your first yearof business ownership. You also need to make sure you come out of thestarting gates with well-organized and accurate financial statements. SeeChapter 19 for more details.Much like a first-time home buyer’s excitement at moving into a newly purchasedhome, your euphoria at owning your business may quietly slip intoanxiety when you realize that your work is just beginning. Relax, take deepbreaths, and use the time-tested method of breaking a big task into manysmaller manageable ones. Also, rest assured that if you take the advice weoffer throughout Part II and you do your homework before buying your business,you should end up purchasing a company that doesn’t have majorproblems and that you have the skills to run well.
65 structure. Don’t make rash changes in this area, especially if you’re thinking about reducing benefits and/orcompensation. Early, negative changes can have ugly long-termconsequences.✓ Walk; don’t run. Don’t make huge changes your first day, week, or evenmonth at the helm. Take your time to discover the culture of the business,the needs of its customers, and the idiosyncrasies of its vendorsbefore you attempt to make major changes. Employees, customers, andvendors don’t like quick change, especially when the person behind thechange is new and relatively unknown.✓ Consult the prior owner. Don’t expect to know everything there is toknow about running your new business. No matter how much better abusiness manager you may think you are than your predecessor, he orshe has certain knowledge and skills that you don’t have. Don’t let yourego stand in the way of asking the previous owner for advice.✓ Work with a good tax advisor. You don’t want to fall behind in filingyour taxes or filling out the right tax forms, or you’ll have a nasty surprisein the form of an unexpectedly large tax bill. The tax advisor whohelped you with evaluating your business purchase may be able to recommenda tax advisor you can work with at least during your first yearof business ownership. You also need to make sure you come out of thestarting gates with well-organized and accurate financial statements.Much like a first-time home buyer’s excitement at moving into a newly purchasedhome, your euphoria at owning your business may quietly slip intoanxiety when you realize that your work is just beginning. Relax, take deepbreaths, and use the time-tested method of breaking a big task into manysmaller manageable ones. Also, rest assured that if you take the advice offerred and you do your homework before buying your business,you should end up purchasing a company that doesn’t have majorproblems and that you have the skills to run well.
66 One of the least-pleasant aspects of starting and running a small business is comprehending and adhering to the myriad government regulationsthat affect how and where you do business. Not to mention the plethora oflegal issues that can blow up in your face and culminate in a lawsuit.And if the thought of these penalties isn’t enough, we have what we hope isan incentive for you to familiarize yourself with the issues raised in this chapter:We can save you time and headaches by showing you how to efficientlyand correctly complete important legal and regulatory tasks.Navigating Small-Business LawsYou may think that if you’re starting or operating a truly small small business,you don’t need to know much on the legal and regulatory fronts. Wewish that were true, but it’s not. Consider the following types of issues thatmost small-business owners must grapple with, both in the early years oftheir businesses and on an ongoing basis:
67 ✓ Selecting a name for your business: You can’t simply choose any name and start using it for your business. After all, you may select a name thatanother business is already using, and that owner could take legal actionagainst you. Besides, you’ll probably spend a lot of marketing moneyover the years to distinguish your business from the masses, and youdon’t want people (especially your customers) to confuse your businesswith someone else’s.✓ Complying with government licensing and permit requirements:Federal, state, and sometimes even local governments regulate andlicense certain types of businesses, such as restaurants, taxicabs, andbeauty shops.If you’re operating a business that requires registration with particulargovernment entities, the passing of certain exams, or the satisfactionof specific licensing requirements, you’ll be breaking thelaw and may be put out of business if you don’t comply. The possiblepenalties for running afoul of business laws can be steep and can includemonetary fines and outright prohibition against practicing your line ofwork for months or even years. And if that isn’t bad enough, your transgressionsmay become public knowledge (and permanently etched intothe Internet), which can hamper your ability to get your business up andrunning again when you’re legally able to do so.✓ Protecting your ideas and work: If you prepare a business plan anddistribute it for comment or to raise money, youdon’t want anyone to steal your ideas, do you? If you invent or brainstormsomething new and unique, you don’t want someone else to copyyour creation and profit from it, do you? Well, if you don’t properly protectyour ideas, work, and other creative developments through trademarks,copyrights, and patents, someone could rip you off and you’llhave little, if any, legal recourse.✓ Establishing a retirement plan: Perhaps you’ve heard of retirementplans such as profit sharing, money purchase pension plans, SEP-IRAs,and so on. Over the years, these plans can slash tens, and maybe evenhundreds, of thousands of dollars off your tax bill. However, if youhave employees, they’re entitled to certain retirement benefits that aresubject to federal regulations. Your reward for violating retirementplanrules can be the disallowance of your contributions into the plan,thereby causing you to owe the IRS taxes and penalties — ouch!✓ Filing your taxes: As a business owner and self-employed person, you’reresponsible for properly filing all federal, state, and local taxes for yourselfand your business. And when you employ others, you must withhold
68 appropriate taxes from their wages and submit the withheld taxes in a timely fashion to the various tax regulatory authorities. More than a fewsmall businesses have failed because the owners fell behind on taxesand subsequently were buried by past-due payments.✓ Hiring and managing employees: Employment law is a vast and growingarea of the legal profession. When you hire and employ workers, youmust be careful about what you say to them and how you manage andbehave around them. If you’re not careful, you can face big legal billsand possible lawsuit damages, while the reputations of you and yourhard-earned business are dragged through the mud during legal proceedings.✓ Preparing contracts: In many ways, contracts make the business worldgo ’round. When properly prepared, contracts function as legally binding,enforceable agreements that your business makes with suppliers,employees, and others relating to the operation of your business. If youoffer a contract to another person or business or seek to change theterms and conditions of an existing contract, you must first understandthe legal ramifications. If you don’t understand these ramifications, at aminimum, you’ll have to deal with upset parties on the other end of thecontract; in the worst cases, you could end up in court with soaring legalbills and potential lawsuits.
69 Suffering through Start-Up Regulations Before you begin working with your first customer, you need to invest timeand money into getting your legal and regulatory ducks in a row. In the start-upphase of a small business, however, few business owners have the luxury ofspending hard-to-spare time and money on these issues. So in this section, weassist you in saving some of both while helping you protect your business.Complying through licensing,registrations, and permitsYears ago, when Eric started his financial counseling practice, the firstthing he did was investigate what government regulatory organizationshe needed to register with. To his surprise, he had to register with boththe federal Securities and Exchange Commission (SEC) and his state’sDepartment of Corporations. He was surprised because he figured that aprofession as full of deception, conflicts of interest, and outright cases ofcorruption as the financial planning profession would’ve had less governmentoversight. (Then again, government “oversight” of a profession canliterally result in oversights!)
70 To discover the various ways in which different government bodies regulate your line of business, we suggest you check with the following:✓ Trade associations for your business or profession: Most lines of businesshave active trade associations, whose management and memberscan share war stories and information about regulations. Obviously,association members in your local area will have far more relevant experiencesto share, assuming they aren’t competitors. Check out the Small Business Sourcebook (a useful reference publicationpublished by Gale), which you can probably find at your local library.✓ Peers in your profession: Those who have been there and done thatcan save you time by sharing their experiences. The simplest way tonetwork with others in your line of work is to attend conferences or conventionsfor your industry or profession. Again, trade associations canhelp you locate such events, or you can network in your local area.A downside of the local-area strategy is that people in the same line ofwork in your town may view you as competition and be less than forthcomingwith assistance. Also, keep in mind that others may or may nothave done a thorough job of researching regulatory requirements andmay have chosen not to comply with certain regulations.If you’re fortunate enough to live in a community that has a businessincubator, stop in and inquire about one or more of itslessees. They are, by definition, people who recently went through thesame thing you’re going through now.✓ The state agency that oversees corporations and/or small businesses:Check out the state government section in your local phone directoryor peruse your state’s website to find the right number to call. Look forany of the following state government agencies: Economic DevelopmentDepartment, Department of Commerce, or the Office of Small Business.When you make the call, be persistent, because if the person whoanswers the phone is poorly trained or having a bad day, you may notget the information you need and you may have to start over again witha different department.✓ Other relevant local government agencies: Let your fingers do the walkingthrough the government (city, county, and federal) section of yourlocal phone directory. For tax issues, look under Tax Collector. For real
71 Department. For health-related issues, look under Health Department. If you get stuck and can’t reach the correct department, most cities andtowns have a city clerk or town clerk who can transfer you to the rightdepartment.✓ Trade publications: You may be surprised at how many specializedoccupational publications exist. You can research past articles on industry regulationsin such publications. (You may need to contact the publicationfor a listing of topics covered in prior issues, or you can check out thepublication’s website for an internal search engine.)✓ The local Chamber of Commerce: Most communities have a localChamber of Commerce; the better ones have helpful information forprospective and current small-business owners (including the applicablegovernment organizations you need to check in with and the otherpeople you need to speak to).✓ Small Business Development Centers (SBDCs): Every state has an SBDC,and most SBDCs have extensive small-business libraries, as well as awide variety of pamphlets and brochures, compliments of the applicablegovernment organizations.✓ Experienced small-business advisors: Tax and legal advisors, as well asconsultants experienced with businesses like yours, can help point youin the right direction. Although such advisors generally charge a heftyhourly fee, the advice can be well worth the price if you select a goodadvisor. An advisor may even be willing to offer free tips on generalregulatory issues in order to cultivate your future business.✓ Real estate agents and building contractors: If your business willoperate in a commercial or retail space, you can acquire knowledge byconversing with agents who sell or lease space and/or contractors whodevelop and renovate space similar to what your business will occupy.
72 In the next sections, we dig deeper into the realities of compliance and the local, state, and federal regulations you must follow.The realities of complianceVarious government agencies — at the local, regional, state, and federallevels — impose all sorts of licensing, registration, and permit requirementson small-business owners. If you’ve ever arrived in a new city without a mapand tried to get around by yourself in a car, you already know what it may belike as you try to discover all the agencies and paperwork required for thetype of business you want to operate.If you overlook applying for one important permit or license, the governmentcan slap you with hefty fines, and disgruntled customers can sue you,using your lack of compliance with government regulations as an indicator ofslipshod business practices. And even if you’re a good enough detective toferret out and understand the government regulations with which you mustcomply, you may tear out your hair trying to determine the right order inwhich to obtain your permits and licenses.Okay, so life could be worse — you could live in a communist country wheresuch permits are available only to the highest bidders! Just remember tokeep your eyes and ears open. Talk to as many people as you can and rememberthat the burden for compliance falls on your shoulders. Don’t toss yourhands in the air, say that compliance with government regulations is too hardto figure out, and just wing it.The success or failure of a business often lies in the details — or, more specifically,in the owner’s willingness to pay attention to them. Complying with allapplicable regulations is an early test!
73 Local regulations: Taxes, zoning, and health The town, city, and county in which you operate your business more thanlikely impose some requirements on businesses like yours. Even if you operatea home-based business, you can’t assume that you can do what you wantwhen and where you want to do it because home-based businesses often areeven more restricted than their office-park counterparts.Some common local regulations that affect small-business owners include thefollowing:✓ Taxes: In most areas, if you’re selling products through a retail store,you have to collect sales tax. In fact, even if you don’t operate a retailstore, you may have to collect sales tax on products you sell, and somecities tax all revenue from small businesses. Plus, you may be surprisedto discover that some communities levy an annual property tax on certainbusiness assets such as inventory, equipment, and furniture.✓ Fictitious name: If the name of your business is different from your ownname, you need to file what’s known as a fictitious name or doing businessas (DBA) form. You usually file your DBA form through the county, andyou may have to publish your DBA filing in a local newspaper.✓ Real estate: All real estate is affected by zoning, which restricts the useof a given property. If you don’t like the idea of local government tellingyou what you can and can’t do on your property, consider how you’dfeel if your next-door neighbor opened a chicken and pig farm on hisproperty! Whether you’re leasing or buying a property, you’ll have todeal with zoning ordinances.
74 Local regulations: Taxes, zoning, and health The town, city, and county in which you operate your business more thanlikely impose some requirements on businesses like yours. Even if you operatea home-based business, you can’t assume that you can do what you wantwhen and where you want to do it because home-based businesses often areeven more restricted than their office-park counterparts.Some common local regulations that affect small-business owners include thefollowing:✓ Taxes: In most areas, if you’re selling products through a retail store,you have to collect sales tax. In fact, even if you don’t operate a retailstore, you may have to collect sales tax on products you sell, and somecities tax all revenue from small businesses. Plus, you may be surprisedto discover that some communities levy an annual property tax on certainbusiness assets such as inventory, equipment, and furniture.✓ Fictitious name: If the name of your business is different from your ownname, you need to file what’s known as a fictitious name or doing businessas (DBA) form. You usually file your DBA form through the county, andyou may have to publish your DBA filing in a local newspaper.✓ Real estate: All real estate is affected by zoning, which restricts the useof a given property. If you don’t like the idea of local government tellingyou what you can and can’t do on your property, consider how you’dfeel if your next-door neighbor opened a chicken and pig farm on hisproperty! Whether you’re leasing or buying a property, you’ll have todeal with zoning ordinances.
75 given location, as well as plan on dealing with the good folks in City Hall if you want to do any renovations to your place of business. If those renovationsraise any environmental concerns — such as disturbing orremoving potentially hazardous substances like asbestos — you mayneed to involve your local health department as well (see the nextbullet). Zoning and renovation issues often come into play when a homeofficebusiness steadily grows and the owner finally decides to add on tohis house or garage in order to hire another employee or carry moreproducts in inventory or when the business generates a level of activitythat affects noise levels, traffic, and parking demands.✓ Health and safety: Small-business owners whose enterprises involvefood are subject to all sorts of regulations from the local health department.For instance, you may need to have your water tested occasionallyif you live in a less densely populated area that uses well water. Anddon’t overlook the myriad safety regulations, such as local fire codesand elevator inspections.State regulations: More taxes, licensing,insurance, and the environmentIn addition to regulations at the local level, states impose requirements onbusinesses, and you need to be aware of, and comply with, these requirements.Most states have established agencies to assist business owners withdoing business in the state. After all, states do have some vested interestin trying to attract and retain businesses because business tax revenues filltheir coffers.Here are the primary issues that may affect your small business due to stateregulations:✓ Licenses: State licensing is primarily intended to reduce the consumer’slikelihood of being fleeced or victimized. Although some occupations(such as doctors and lawyers) are universally required to be licensed,each state has a unique list of occupations that it regulates.State licensing requirements vary by occupation and by state. In somestates, you can get certain licenses after you complete a few forms andpay the state a fee. In most cases, however, you have to take a test orcomplete some form of certification in order to get a license.✓ Taxes: As we discuss in the local regulations section, some businesses,such as retailers, have to collect sales tax on products sold. In moststates, all businesses must pay income taxes at the state level
76 employee-related insurance will feel like another tax employee-related insurance will feel like another tax. Common staterequiredcoverage includes workers’ compensation, which compensatesworkers for lost wages due to job-related injuries, and unemploymentinsurance, which pays laid-off employees for a certain period of time oruntil they secure another job.✓ Environment: If you’re a manufacturer and your plant emits unsavorysmoke, particles, or odors into the air or water, you can be certainthat your state (and possibly other government agencies) will regulateyour activities — and for good reason. Left to their own devices, someunsavory business owners would knowingly pollute because installingcontrol devices would add to the cost of doing business, effectivelyreducing profits.Federal regulations: Still more taxes, licenses, and requirementsIn addition to local and state regulations, small-business owners must complywith U.S. federal government regulations, which cover taxes and licenses aswell as the health, safety, and welfare of your employees.Not all federal labor laws affect all small businesses because some issuesapply only to employers with a specific number of employees. So the goodnews may be that your small business is small enough that you don’t have toconcern yourself with all the issues we cover in the following list. (Find outwhat issues apply to your business by consulting the resources listed in thesection “Complying through licensing, registrations, and permits.”)Here are the key federal regulations most small-business owners need toconsider:✓ Licenses: Most businesses that require a license or permit to operategenerally obtain the documentation at the state level. Some businesses,however, receive permits and licenses at the federal level. These businessesinclude alcohol and tobacco manufacturers, drug companies,firearm manufacturers and dealers, investment advisors, meat packingand preparation companies, radio and television stations, and truckingand other transportation companies.✓ Taxes: All incorporated businesses, or their owners if the businessisn’t incorporated, must file a federal income tax return. Additionally,most small-business owners — especially those who hire employees —choose to apply for and utilize a federal Employer Identification Number(EIN).✓ Americans with Disabilities Act (ADA): This legislation prohibitsemployers with 15 or more employees from discriminating against prospectiveand current employees or customers with disabilities. Such
77 discrimination is barred in the hiring, management, and dismissal of any employee. For example, during the process of interviewing job applicants,you can get yourself into a heap of legal hot water if you excludefrom consideration qualified candidates who are in some way disabled.✓ Family and Medical Leave Act: This legislation requires employerswith 50 or more employees (within 75 miles) to provide up to 12 weeksof unpaid leave to employees who desire or need the leave for personalhealth issues due to a serious medical condition that affects the employee’sability to perform the regular duties of his or her job; to spend timewith a newborn or adopted child; or to care for a family member whohas a serious medical condition.During the term of an employee’s leave, the employer must continue tocover the employee under the company’s group health-insurance planunder the same conditions as when the employee was working.Eligible employees (who have been with the employer for at least oneyear and who have worked at least 125 hours over the previous year)who take a leave under the Family and Medical Leave Act generallycan do so with the understanding that they can return to their samepositions with the same pay and benefits. So-called highly paid “key”employees aren’t guaranteed the same positions and compensationpackages if their returns would lead to significant economic harm to theemployers. (The Department of Labor defines a key employee as a salariedemployee “. . . who is among the highest paid 10 percent of employeeswithin 75 miles of the work site.”)✓ 2010 federal health-insurance legislation: Congress passed sweepinghealth-insurance legislation in 2010 that affects and will affect manysmall businesses.Selection of a business entityIn the start-up phase of your business, be sure to consult your attorney or taxadvisor about what type of organization or business entity — for example,sole proprietorship, partnership, corporation, or limited liability company(LLC) — makes sense for your enterprise. Although the different corporateentities that you may form for your business can provide some legal protectionfor you and your personal assets, establishing such entities involvessignificant time and expense and doesn’t completely insulate you and yourcompany from lawsuits.Given the excitement and stresses inherent in the early days of running asmall business, we can understand why you may not care to spend yourprecious time and money on researching and consulting with legal and taxexperts about what type of organization you should establish.
78 Protecting ideas: Nondisclosures, patents, trademarks, and copyrightsYour business idea and business plans probably aren’t 100 percent unique.Some business owners, however, have taken a different twist on somethingor have created a truly unique product or service. But even if you don’t havea unique or different product or service to offer, you don’t want others tosteal your plans and ideas. By circulating copies of your business plan , you may be giving away much of your hard work and ideas to anindividual or another business that can end up being a competitor.The following sections explain what you need to know about protecting yourbusiness and ideas in general and specifically through nondisclosures, trademarks,patents, and copyrights.General tips for protecting your ideasHere are some tips for how to protect your business plan and ideas:✓ Be careful about who sees your business plan. A friend or advisor whohappens to know a lot about your type of small business, or small businessesin general, is unlikely to have unfriendly motives in looking atyour plan. On the other hand, an industry insider or a potential competitorwho peruses your plans may not have your best interests at heart.✓ Keep proprietary information out of your plan. Don’t include productdesigns, manufacturing specifications, unique resources, or other informationunique to your company in the copies of your business plan thatyou distribute to others. Share such information with serious investorsonly if needed to gain their investments, and do so with a nondisclosureagreement attached (see the next section).✓ Place a nondisclosure statement in the front of your business plan. Ifyour plan does fall into the hands of someone who may be inclined tosteal your ideas, a nondisclosure statement (which we discuss in thenext section) should scare them off.✓ Get legal assistance when necessary. If your work and ideas are proprietaryand protectable, speak with an attorney who specializes in intellectualproperty, including copyrights, trademarks, and patents. We explainthese important legal protections in the upcoming section “Patents,trademarks, and copyrights.”Nondisclosure agreements (NDAs)Always be sure to attach a nondisclosure agreement (NDA) to the beginning ofyour business plan before you circulate it for review. The purpose of the NDAis to warn the reader that the enclosed contents are private property and
79 attorney to craft this agreement.) are not to be spread around without your consent. (Note: You don’t need anattorney to craft this agreement.)Simply including the NDA with your business plan isn’t enough; never handout your plan without first having the recipient sign the NDA.Following is a sample nondisclosure agreement:This confidential Business Plan has been prepared in order to raisefinancing for Wowza Widgets, Inc. This material is being delivered to aselect number of potential investors, each of whom agrees to the followingterms and conditions:Each recipient of this Business Plan agrees that, by accepting this material,he or she will not copy, reproduce, distribute, or discuss with othersany part of this plan without prior written consent of Wowza Widgets, Inc.The recipient agrees to keep confidential all information contained hereinand not use it for any purpose whatsoever other than to evaluate anddetermine interest in providing financing described herein.This material contains proprietary and confidential information regardingWowza Widgets, Inc., and is based upon information provided toWowza Widgets, Inc., by sources deemed to be reliable. Although theinformation contained herein is believed to be accurate, Wowza Widgets,Inc., expressly disclaims all liability for any information, projections, orrepresentations (expressed or implied) contained herein from omissionsfrom this material or for any written or oral communication transmittedto any party in the course of its evaluation for this financing. The recipientacknowledges that this material shall remain the property of WowzaWidgets, Inc., and Wowza Widgets, Inc., reserves the right to request thereturn of the material at any time and in any respect, to amend or terminatesolicitation procedures, to terminate discussions with any and allprospective financing sources, to reject any and all proposals, or to negotiatewith any party with respect to the financing of Wowza Widgets, Inc.The projections contained in the pro-forma Financial Section are basedupon numerous assumptions. Although Wowza Widgets, Inc., believesthat these assumptions are reasonable, no assurance can be given as tothe accuracy of these projections because they are dependent in largepart upon unforeseeable factors and events. As a result, the actual resultsachieved may vary from the projections, and such variation can be materialand adverse.Signature (print): __________________________________________________Signature: _________________________________________________________
80 Patents, trademarks, and copyrights You may have created a product, service, or technology unique enough thatyou want to prevent others from copying it. Or maybe you simply want torestrain others from using and profiting from the name of your business orliterary, musical, or artistic creations.Welcome to the wonderful and often confusing world of patent, copyright,and trademark law. You’ll be relieved to hear that this isn’t a legal book,in part because your two humble authors are, happily (for us at least), notlawyers. And most small-business owners don’t need to spend much time orlegal expense on these issues.If you do need to deal with patents, copyrights, or trademarks, you have tobe familiar with the following very important terms. For more information,consult a lawyer who specializes in intellectual property.✓ Patent: If you’ve invented something (such as a new type of toy orcomputer disk), you may want to explore patenting your invention. Thereason: By filing a patent with the federal government, you have exclusiverights to manufacture, sell, and use the patented invention. Youcan, if you so choose, license usage of the patent to others.✓ Trademark: Companies invest significant time, effort, and money intocreating brand names (for example, Coca-Cola and For Dummies),marketing strategies, advertising slogans (Making Everything Easier!),logos (the Dummies Man on this book’s cover or the Nike swoosh,for instance), and so on. The point of the trademark is to protect yourbrands and prevent other enterprises from using and profiting from therecognition and reputation you’ve developed through your business’sbrand names, marketing/advertising images, and the words associatedwith your product.Trademarked items can also include things such as the packaging,shape, character names, color, and smell associated with a product. Ifyou think your business has identifying characteristics that you don’twant copied by competitors, think about applying for trademark protection.Note: Patents and trademarks are handled by the U.S. Patent andTrademark Office (www.uspto.gov); copyrights are the domain of theU.S. Copyright Office (www.copyright.gov).✓ Copyright: Copyright laws cover such works as musical and soundrecordings, literary works, software, graphics, and audiovisuals. Theowner of the copyright of a work is solely allowed to sell the work,make copies of it, create derivations from it, and perform and displaythe work. The creator of the work isn’t always the person or part of theorganization that holds the copyright, though. For example, writerssometimes do freelance writing for publications that hold the copyrightto the work that their writers create for them.
81 authorship yourself to save money. A two-page form is available from the U.S. Copyright Office (www.copyright.gov/forms; ).Follow the directions and you can register your copyright yourself. Youmust pay a modest filing fee for each request, but you can put similarworks on one form.No copyright cops are out there searching for people who are violating yourpatents, trademarks, or copyrights. The burden is on you to perform thedetective work yourself; if you detect a violation, head immediately for anattorney.A business prenup: Contracts withcustomers and suppliersAll small businesses have customers as well as suppliers (or vendors). Inboth of these relationships, small-business owners often engage in contracts,whether formally written or verbal. Here are our tips for dealing with contractswith your customers and suppliers:✓ Get it in writing. Otherwise, you have little or no recourse if someone(such as a supplier) doesn’t deliver as promised.✓ Don’t make promises verbally that you aren’t willing to put into writing.What you say can get you into trouble, especially in terms of yourcustomers and advertising.✓ Get a legal perspective. You need to seeklegal assistance for small-business operation issues at various times inthe life of your business. When you’re drafting contracts is one of thosetimes.Whether or not you should develop a contract with a vendor or a customerdepends on the situation. If, for example, you’re working with a local customeror vendor — especially someone you know — and you think he maybe offended by your request for a formal contract, sticking with handshakesis fine. If, however, you happen to land a whale for a customer or you orderproducts from a large vendor, neither of whom you have a personal relationshipwith, you should definitely initiate a formal contract.In fact, most large companies — whether they’re customers or vendors —expect a formal contract as part of the package. If they don’t get one, theymay wonder about your ability to work with them on a professional level. Ifthe professionalism issue isn’t enough to convince you to develop a formal
82 contract, let self-preservation be your motivator contract, let self-preservation be your motivator. After all, large businessesdon’t always have small businesses’ best interests in mind. Why not lock inyour safety with a contract?Laboring over Employee Costs and LawsWhen your business begins to hire employees, the good news is that it hasprobably gotten off the ground sufficiently well enough to afford the costsassociated with hiring and managing them. The bad news is that, besides thesalary you pay your employees, you’ll encounter several significant “hidden”costs, including the following✓ Taxes: On top of your employees’ salaries, you’re also responsible forpaying Social Security taxes on their earnings, as well as other taxes,such as unemployment insurance. When hiring, you must be carefulabout whether you hire people as employees or independent contractors.Many small-business employers prefer to hire people as independentcontractors because doing so lowers their tax bills, but the IRS hasstrict rules for who qualifies as an independent contractor. If you classifysomeone as a contractor who should be considered an employee,you could end up facing stiff penalties.✓ Employee benefits: Various insurance programs, paid vacation, andretirement plans help attract and retain employees. The smallest smallbusinesses can’t afford to offer many employee benefits, but you shouldknow your options and be aware of what your competition is offering.✓ Government regulations: Are you surprised that a host of local, state,and federal government regulations dictate, mandate, and cajole yourhiring, management, and dismissal of employees? You shouldn’t be ifyou’ve read this chapter all the way through!✓ Employee lawsuits: Don’t think that just because you’re not running abillion-dollar enterprise you can’t and won’t be sued. Although someemployee suits are frivolous, others are caused by employers not exercisingproper care when dealing with employees. .
83 Mastering Small-Business Taxes ▶ Managing your business taxes and maintaining sound financial records▶ Identifying and managing your tax bracket▶ Understanding employee tax issues▶ Using sensible tax write-offs▶ Choosing a tax-friendly corporate entity
84 WELFARE SYSTEMThe U.S. social welfare structure has been shaped both by long standing traditions and by changing economic and social conditions. In its early history, the United States was an expanding country with a vast frontier and a predominantly agricultural economy. Up to 1870, more than half the Nation’s adult workers were farmers. In the years that followed, however, industry developed rapidly and the economy tended increasingly to be characterized by industrialization, specialization, and urbanization. The result was a Nation of more employees who were dependent on a continuing flow of money income to provide for themselves and their families.From the earliest colonial times, local villages and towns recognized an obligation to aid the needy when family effort and assistance provided by neighbors and friends were not sufficient. This aid was carried out through the poor relief system and almshouses or workhouses. Gradually, measures were adopted to provide aid on a more organized basis, usually through cash allowances to certain categories among the poor. Mothers’ pension laws, which made it possible for children without paternal support to live at home with their mothers rather than in institutions or foster homes, were adopted in a number of States even before World War I. In the mid-twenties, a few States began to experiment with old-age assistance and aid to the blind.Meanwhile, both the States and the Federal Government had begun to recognize that certain risks in an increasingly industrialized economy could best be met through a social insurance approach to public welfare. That is, the contributory financing of social insurance programs would ensure that protection was available as a matter of right as contrasted with a public assistance approach whereby only those persons in need would be eligible for benefits.In the United States, as in most industrial countries, social insurance first began with workers’ compensation. A Federal law covering civilian employees of the Government in hazardous jobs was adopted in 1908, and the first State compensation law to be held constitutional was enacted in By 1929, workers’ compensation laws were in effect in all but four States. These laws made industry responsible for the costs of compensating workers
85 or their survivors when the worker was injured or killed in connec tion with his or her job. Retirement programs for certain groups of State and local government employees—mainly teachers, police officers, and fire fighters—date back to the 19th century. The teachers’ pension plan of New Jersey, which was established in 1896, is probably the oldest retirement plan for government employees. By the early 1900’s, a number of municipalities and local governments had set up retirement plans for police officers and fire fighters. New York State and New York City set up retirement systems for their employees in 1920—the same year that the Civil Service Retirement System was set up for Federal employees. Another area where the Federal Government accepted an earlyresponsibility was in the provision of benefits and services forpersons who served in the Armed Forces. These veterans’ benefitsat first consisted mainly of compensation for the war-disabled,widows’ pensions, and land grants. Later, emphasis was placed onservice pensions and domiciliary care. Following World War I,provisions were made for a full-scale system of hospital and medical care benefits.
86 The development of social welfare programs has been strongly pragmatic and incremental. Proposals for change are generally formulated in response to specific problems rather than to a broad national agenda. A second characteristic of U.S. social welfare policy development is its considerable degree of decentralization. Some programs are almost entirely Federal with respect to administration, financing, or both; others involve only the States (with or without participation of local government); still others involve all three levels of government. The important role played by the private sector is another aspect of decentralization in the development of American social welfare programs. The private sector shares a large role in the provision of health and medical care and income maintenance benefits in the form of employment related pensions, group life insurance, and sickness payments.The severe Depression of the 1930’s made Federal action a necessity, as neither the States and the local communities nor private charities had the financial resources to cope with the growing need among the American people. Beginning in 1932, the Federal Government first made loans, then grants, to States to pay for direct relief and work relief. After that, special Federal emergency relief and public works programs were started. In 1935, President Franklin D. Roosevelt proposed to Congress economic security legislation embodying the recommendations of a specially created Committee on Economic Security. There followed the passage of the Social Security Act, signed into law August 14, 1935.
87 Social Security ActTitle I Title II Title IIITitle IV Title V Title VI Title VII Title VIII Title IXTitle X Title XI Grants to States for Old-Age AssistanceFederal Old-Age BenefitsGrants to States for Unemployment Compensation AdministrationGrants to States for Aid to Dependent ChildrenGrants to States for Maternal and Child WelfarePublic Health WorkSocial Security BoardTaxes with Respect to Employment (for Old-Age Insurance)Tax on Employers of Eight or More (for administration of unemployment compensation)Grants to States for Aid to the BlindGeneral Provisions
88 This law established two social insurance programs on a national scale to help meet the risks of old age and unemployment: a Federal system of old-age benefits for retired workers who had been employed in industry and commerce, and a Federal-State system of unemployment insurance. The choice of old age and unemployment as the risks to be covered by social insurance was a natural development, since the Depression had wiped out much of the lifetime savings of the aged and reduced opportunities for gainful employment.The Act also provided Federal grants-in-aid to the States for the means-tested programs of Old-Age Assistance, and Aid to the Blind. These programs supplemented the incomes of persons who were either ineligible for Social Security (Old-Age and Survivors Insurance) or whose benefits could not provide a basic living. The intent of Federal participation was to encourage States to adopt such programs.The law established other Federal grants to enable States to extend and strengthen maternal and child health and welfare services, and these grants became the Aid to Families with Dependent Children program, which has been replaced in 1996 with a new block grant program for Temporary Assistance for Needy Families. (The Act also provided Federal grants to States for public health services and services of vocational rehabilitation. Provisions for these grants were later removed from the Social Security Act and incorporated into other legislation.)The Old-Age Insurance program was not actually in full operation before significant changes were adopted.
89 In 1939, Congress made the Old-Age Insurance system a family program\ when it added benefits for dependents of retired workers and surviving dependents of deceased workers. Benefits also becamefirst payable in 1940, instead of 1942 as originally planned. No major changes were made again in the program until the 1950’s, when it was broadened to cover many jobs that previously had been excluded—in some cases because experience was needed to work out procedures for reporting the earnings and collecting the taxes of persons in certain occupational groups. The scope of the basic national social insurance system wassignificantly broadened in 1956 through the addition of DisabilityInsurance. Benefits were provided for severely disabled workersaged 50 or older and for adult disabled children of deceased orretired workers. In 1958, the Social Security Act was furtheramended to provide benefits for dependents of disabled workerssimilar to those already provided for dependents of retired workers.In 1960, the age-50 requirement for disabled-worker benefits wasremoved. The 1967 amendments provided disability benefits forwidows and widowers aged 50 or older.
90 The 1972 amendments provided for automatic cost-of-living increases in benefits tied to increases in the Consumer Price Index (CPI), and created the delayed retirement credit, which increased benefits for workers who retire after the normal retirement age (currently age 65). The 1977 amendments changed the method of benefit computation to ensure stable replacement rates over time. Earningsincluded in the computation were to be indexed to account forchanges in the economy from the time they were earned. The 1983 amendments made coverage compulsory for Federal civilian employees and for employees of nonprofit organizations. State and local governments were prohibited from opting out of the system. The amendments also provided for gradual increases in the age of eligibility for full retirement benefits from 65 to 67, beginning with persons who attain age 62 in the year For certain higher income beneficiaries, benefits became subject to income tax. The amendments in 1994 raised the threshold for coverage ofdomestic workers’ earnings from $50 per calendar quarter to$1,000 per calendar year (with $100 amount increments after 1995,as average wages rise).
91 By the 1930’s, private industrial pension plans were far more Changes developed in the rail industry than in most other businesses or industries; but these plans had serious defects that were magnified by the Great Depression. While the Social Security system was in the planning stage, railroad workers sought a separate railroad retirement system that would continue and broaden the existing railroad programs under auniform national plan. The proposed Social Security system was not scheduled to begin monthly benefit payments for several years and would not give credit for service performed prior to 1937, while conditions in the railroad industry called for immediate benefit payments based on prior service.Legislation was enacted in 1934, 1935, and 1937 to establish a railroad retirement system separate from the Social Security program legislated in While the railroad retirement system has remained separate from the Social Security system, the two systems are closely coordinated with regard to earnings credits, benefit payments, and taxes. The railroad unemployment insurance was also established in the 1930’s.Other programs also made advances in the period since In 1948, the last of the States adopted a workers’ compensation program. The laws relating to work-connected accidents gradually improved the provisions for medical benefits and rehabilitation extension services.During the 1940’s, four States adopted legislation providing weekly cash sickness benefits to workers who are temporarily disabled because of nonoccupational illness or injury. For Federal civilian employees, programs were enacted providing group life insurance in 1954 and health insurance benefits in Since then, an increasing number of State and local government jurisdictions initiated retirement programs for their employees. At present more than 75% of all State
92 and local employees are covered both by the basic national OASDI program and by a supplementary State or local system.As a result of World War II and the Korean conflict, special veterans’ legislation was enacted, with primary emphasis on assisting ex-servicepersons to adjust from military to civilian life. Not only were the older compensation and pension benefits available to World War I veterans carried forward, but veterans were provided vocational rehabilitation, unemployment allowances, educational and training benefits, and job placement services.One of the most important pieces of social legislation was the establishment of the Medicare program under the Social Security Amendments of The program provided for the medical needs of persons aged 65 or older, regardless of income.The 1965 legislation also created Medicaid (Federal grants to States for Medical Assistance Programs). Medicaid provides medical assistance for persons with low incomes and resources. It replaced the former programs of medical vendor payments to public assistance recipients and medical assistance for medically needy persons aged 65 or older. Both Medicare and Medicaid have been subject to numerous legislative changes since 1965.The public assistance provisions of the Social Security Act were also broadened. In 1972, the State-administered cash
93 assistance programs for the aged, blind, and disabled were replaced by the essentially federally administered Supplemental Security Income (SSI) program.Other assistance programs not included in the Social Security Act were also broadened or new ones added. The Food Stamp program was enacted in 1964 to improve the nutrition of low-income families. Other nutrition programs include the Special Supplemental Food Program for Women, Infants, and Children (WIC) and school breakfasts and lunches. In addition, Federal-State programs provide home energy assistance, and public and subsidized housing.The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (Public Law ) resulted in significant changes to public assistance programs. The Aid to Families with Dependent Children program has been replaced by block grants to the States for Temporary Assistance for Needy Families. The legislation also has substantial implications for the SSI and Medicaid programs, which is explained in the individual program sections.Although there is no system of family allowances in the United States, workers with dependent children are given deductions in the computation of their Federal income tax liability, and the working poor receive an additional reduction in their tax liability. Free public education is available to all children through secondary schools.
94 Development of U.S. Social Security Programs Programs 1935 Social Security Old-Age Insurance; Unemployment Insurance; and Public Assistance programs for needy aged, and blind (replaced by the SSI program in 1972); and Aid to Families with Dependent Children (replaced with block grants for Temporary Assistance for Needy Families in )1934 Railroad Retirement System1937 Public Housing1939 Social Security Old-Age and Survivors Insurance1946 Natonal School Lunch Program1950 Aid to the Permanently and Totally Disabled (replaced by the SSI program in 1972)1956 Social Security Disability Insurance1960 Medical Assistance for the Aged (replaced by Medicaid in 1965)1964 Food Stamp Program1965 Medicare and Medicaid Programs1966 School Breakfast Program1969 Black Lung Benefits Program1972 Supplemental Security Income Program1974 Special Supplemental Food Program for Women, Infants, and Children (WIC)1975 Earned Income Tax Credit1981 Low-Income Home Energy Assistance1996 Temporary Assistance for Needy Families
95 The Minsky Theory of Financial Crises In a series of works published in the 1980s and early 1990s, HymanMinsky developed an important theory of financial crises.1 This theoryhelps us understand the forces that create financial crises andexplains why these crises occur with such regularity. Minsky spentmost of his career at academic institutions such as Brown, Berkeley, andWashington University in St. Louis. He died in Perhaps becausethe United States and other highly developed nations experienced an16 The Financial Crisis and Federal Reserve Policyunusual period of sustained economic stability in the quarter centuryextending from the severe 1981–1982 worldwide recession through themid- 2000s, Minsky’s work received relatively little attention during hislifetime. However, because his theory of financial crises turned out tobe remarkably prescient in accounting for the unfolding of the chainof events of 2007–2009 throughout the world, Minsky’s work is nowwidely admired and increasingly cited by economists.Minsky argued that capitalism contains a critical flaw: recurringfinancial crises and economic instability are inherent characteristicsof the system. He believed that the nature of banking and financialinstitutions, in becoming increasingly interdependent over time, wouldinevitably lead to major crises that wreak havoc on the nation’s overalleconomy. In Minsky’s framework, the supply of credit plays the centralrole in accounting for financial crises.
96 Minsky’s key hypothesis is that over periods of sustained prosperity, the financial system gradually transitions from financial relationshipsthat are consistent with a stable system to those that lead to financialinstability. Over a lengthy period of good times, a financial structuredominated by conservative hedge finance inevitably gives way to the onein which speculative and Ponzi finance play ever- larger roles. This makesthe system increasingly unstable and fragile. A crisis becomes an accidentwaiting to happen. For example, if the central bank raises interestrates during an economic boom in an attempt to reduce inflation in thepresence of significant elements of speculative and Ponzi finance, assets20 The Financial Crisis and Federal Reserve Policymust be liquidated in order to meet the higher interest obligations. Manyof those initially practicing speculative finance will be forced into Ponzistatus, and those already in Ponzi status will almost surely be forced toliquidate assets financed by the loans. This is likely to result in a chainreaction of falling prices of stocks, bonds, and real estate, with associatedrising debt defaults and bank failures.In essence, Minsky argues that long periods of economic stability inevitablylead to episodes of serious instability. This results from the humanpsychological propensity to exhibit herding behavior, in which peoplebuy a particular asset not because of its fundamental value, but simplybecause others are purchasing it. Because such behavior is inconsistentwith the tenets of rational expectations, the predominant assumption ofmacroeconomic analysis since the “rational expectations revolution” ofthe 1970s, Minsky’s theory did not accord with contemporary economicanalysis during his lifetime. Once again, however, because of its presciencein accounting for the recent worldwide crisis that commenced in2007, the theory has gained increasing attention and respect.
97 CREATION OF THE FEDERAL RESERVE The nineteenth century was a time of periodic systemic banking panicsin the United States. Major panics occurred in 1819, 1837, 1857, 1873,1884, and 1893—an average of about one serious crisis every 17 years.1The panic of 1907 bears a strong resemblance to the earlier panics. It isof great historical significance because it led directly to the creation ofthe Federal Reserve System, the central bank of the United States.On December 22, 1913, Episodic booms and busts characterized nineteenth century U.S. economichistory. Typically, real estate prices would increase rapidly duringperiods when the building of canals, expansion of railroads, or growthof cities created surging demand for land. Credit would expand rapidlyin such periods of prosperity as economic fundamentals and irrationalexuberance joined forces to occasionally inflate real estate and stockprices to astounding levels. Real estate and stocks typically served as collateralfor bank loans, and rising prices of these assets facilitated expansionof credit during the booms.
98 After a period of extraordinary increases in asset prices, an event would occur that would pierce the bubble. In a typical case, this mightinvolve a rumor of an impending insolvency of a famous speculator, bank,or brokerage house. Land and stock prices would then begin to fall asspeculators unloaded assets in an attempt to preserve their profits. As theexisting value of collateral declined below the amount of a bank loan, thebank would ask the borrower for additional collateral. Inability to supplythe necessary collateral typically led to default on the loan. Increasingloan defaults led to bank failures and panics in the form of runs on suspectbanks.
99 The most severe nineteenth century crises occurred in 1873 and These crises were followed by a period of depression characterizedby increasing bankruptcies, rising unemployment, bank failures, andcredit stringency as debt deflation was set in motion.The early years of the twentieth century were times of rising prosperity.Having recovered from the severe panic and accompanying depressionof 1893, the U.S. economy was again booming by the early 1900s.But signs of trouble began to emerge in 1905 and 1906, and by thesummer of 1907 the economy was again in a precarious condition. TheNational Bureau of Economic Research later determined that a recessionhad begun in May. The stock market began falling in March andthe shares of Union Pacific Railroad, widely used as collateral for loans,declined sharply. New York City teetered on the brink of bankruptcyand an offering of new bonds by the city in June failed to attract buyers.2The copper market collapsed in July, and in August it was announcedthat Standard Oil had been fined the enormous sum of $29 million forviolation of antitrust regulations. U.S. stocks were down sharply andbanking runs had recently occurred in Germany, Japan, and Egypt.
100 Trust Companies and Banks Prior to the Civil War, all of the nation’s banks received their operatingcharters from the individual states. The National Banking Act of1863 authorized the chartering of banks by the federal government, thusestablishing the dual banking system. The banks chartered by the federalgovernment were known as national banks and were subject to regulationsspecified in the Banking Act. Banks chartered by individual stateswere governed by state banking regulations. In the absence of a centralbank, organizations known as clearinghouses were formed in large citieslike New York. These organizations were established by groups ofindividual banks that joined forces to pool resources to guarantee bankdeposits and lend cash when needed to sound banks that were membersof the clearinghouse. The clearinghouses served to modestly reduce thepropensity of local banking panics to become systemic.
101 In New York, organizations known as trusts grew rapidly during the decade preceding the panic of Trusts were initially established tomanage the estates of very wealthy clients in the gilded age. Originallyconservatively managed, they were thought to be safe and were thereforesubject to fewer restraints on permissible activities than regular banks.They were less constrained in the types of assets they could purchase andwere not subject to significant reserve requirements. This meant trustscould invest a larger portion of their deposits in earning assets thanbanks. Being subject to less stringent regulation, they could also purchaseriskier assets.Trusts were more profitable and paid a higher rate of return to depositorsthan banks. As economic activity again became robust and memoriesof the banking panic and depression of 1893 dimmed, these trustsbegan to make riskier investments. They earned handsome returns in theearly years of the twentieth century. Taking note of the superior returns,depositors began flocking to these trusts, spurring their growth. In theperiod from 1895 to 1907, total assets of trusts in New York expandedmore than twice as rapidly as those of New York banks and reachedapproximate parity with these banks by As suggested by Minsky’shypothesis, periods of rising prosperity tend to lead to overconfidenceon the part of both borrowers and lenders. This was manifest in increasinglyrisky behavior by the New York trust institutions. As economicactivity boomed in the early 1900s, these trusts began speculating in thestock market and real estate ventures. At first, returns were phenomenal.Then conditions changed for the worse. The Panic of 1907, whichoriginated in the New York trusts, soon threatened to spread throughoutthe nation’s banking system.
102 In the spring of 1906, Fritz A. Heinze arrived in New York City from the West. Heinze was a high- rolling speculator who had amassed a fortunein the copper mining business in Butte, Montana. Upon arriving inNew York, Heinze joined forces with Charles Morse, a banker whosereputation—like Heinze’s—was l ess than impeccable. T ogether, t heybecame affiliated with numerous banks, trusts, and insurance companies,gaining control of several and serving on the board of directors ofmany others.Heinze owned a great number of shares in the struggling UnitedCopper Company back in Montana. Discovering that speculators hadheavily shorted stock in United Copper—that is, had borrowed sharesand sold them with the intention of repurchasing them later at a lowerprice, Heinze and his brother devised a scheme to enhance their personalfortunes by executing a short squeeze on the speculators. In this plan,the brothers would drive up the price of United Copper through massivepurchases of the shares, using funds borrowed from banks with whichthey had connections. They hoped to force the short sellers to cover byrepurchasing shares, most of them from the Heinzes, at much higherprices. If the scheme worked, the Heinze brothers would bankrupt theshort sellers and enrich themselves.
103 Heinze had previously established a banking relationship with Charles Barney, president of the Knickerbocker Trust Company, one ofNew York’s largest and most respected trust organizations. AlthoughBarney had financed previously successful speculations by F.A. Heinze,he turned down the brothers’ request for a large loan. The undauntedHeinze brothers went ahead with the short squeeze, using personalfunds and funds borrowed from other banks with whom they had closeconnections. In mid- October of 1907, they began purchasing sharesof United Copper, pushing the price up sharply. But the brothers hadmisjudged the market. Those who had shorted the stock had alreadyobtained shares to cover their short sales at prices sharply below theelevated prices resulting from the Heinze brothers’ purchases. Withintwo days, the price of United Copper declined by more than 80 percentand the Heinze brothers suffered huge losses.
104 At the time, the State Savings Bank of Butte, owned by Heinze, was holding a large amount of collateral in the form of shares of UnitedCopper posted by those to whom the bank had granted loans. Whenthe shares crashed, the bank demanded additional collateral, which theborrowers were unable to provide. As a result, the loans went bad andthe bank was declared insolvent. News about its demise triggered a massiverun on Mercantile National Bank in New York, recently acquiredby Heinze, which had a correspondent relationship with the Butte bank.In addition to attacking Heinze’s banks, depositors withdrew a largeamount of funds from trusts and banks owned by Morse, Heinze’spartner.The State Savings Bank of Butte was just one of many smaller banksthroughout the nation that had established correspondent relationshipswith larger city banks, many of them located in New York. In these relationships,the small banks held deposits in large banks in New York andother cities in return for services provided by the city banks. When newsof the panic in New York spread, many of these smaller banks withdrewtheir funds from New York banks. In the scramble for liquidity, severalbanks and trust companies, including many of those affiliated withMorse and Heinze, were subject to runs and forced to close. In an effortto prevent a systemic panic in the larger banking system, the New YorkClearinghouse forced the resignations of Heinze and Morse from bankingboards in New York. This served to forestall panic for a short time.
105 However, people became increasingly concerned about known and rumored links between notorious speculators, brokerage houses, andtrusts and banks. Banking is based on confidence, which was starting tobreak down. On Friday, October 18, rumors spread that Charles Barneyhad been involved in the Heinze brothers’ disastrous attempt to cornerthe short sellers in United Copper. This triggered a sustained run onBarney’s Knickerbocker Trust Corporation, which was forced to closeon October 22. The following day, the run spread to the Trust Companyof America, the nation’s second largest trust. It is likely no coincidencethat Barney was a prominent member of its board of directors.
106 However, people became increasingly concerned about known and rumored links between notorious speculators, brokerage houses, andtrusts and banks. Banking is based on confidence, which was starting tobreak down. On Friday, October 18, rumors spread that Charles Barneyhad been involved in the Heinze brothers’ disastrous attempt to cornerthe short sellers in United Copper. This triggered a sustained run onBarney’s Knickerbocker Trust Corporation, which was forced to closeon October 22. The following day, the run spread to the Trust Companyof America, the nation’s second largest trust. It is likely no coincidencethat Barney was a prominent member of its board of directors.
107 John Pierpont Morgan was the principal owner of the U.S. Steel Corporation and the most respected, knowledgeable, and wealthy bankerin New York. He had no direct financial interest in the trust companies.But he realized that this growing panic had the potential to bring abouta disastrous systemic crash and massive depression if it were allowed tospread to the larger banking system. The key l ink involved call loansthat trusts had made to stockbrokers. Such loans can be called in at thediscretion of the lender. Morgan anticipated that continued runs on thetrusts would force a large- scale recall of such loans, which would triggerforced sales of shares of stock. As the decline in stock prices began topush the value of collateral below the amount of the loan, banks wouldsystematically call in the loans, forcing brokers to dump stock, even atfire sale prices, to repay the loans. This, in turn, would create a selfperpetuatingcycle of falling bank capital, bank failures, additional runson banks, and more loan liquidation, credit tightening, and falling assetprices. The final outcome would likely be a major depression.
108 Reckoning that failure of the Trust Company could ignite a disastrous nationwide banking panic, Morgan convened several of the city’s topbankers in a series of late- night meetings in his home. Essentially, thehealthy banks were asked to ante up millions of dollars to shore up theTrust Company of America and other trusts and banks that appearedvulnerable to imminent runs. Morgan agreed to put in $25 million ofhis personal funds, and John D. Rockefeller volunteered to put in up to$40 million if needed. The U.S. Treasury came up with $25 million, andother large banks also contributed to the effort.On October 24, Wall Street observers noted workers carrying bagsof gold and paper currency from the U.S. Treasury’s New York facilityto the trusts and banks designated for help. The word spread and publicpsychology quickly changed. It turned out that the effort spearheadedby Morgan was sufficient to carry the day. While there remained a fewbumps and challenges, the Panic of 1907 ended in early November. Ithad lasted only 6 weeks, and while two dozen trusts had failed, only ahandful of banks had closed down.
109 T he p anic c ontributed appreciably t o the recession that e xtended from May 1907 to June In this period, national output declinedby about 10 percent and the nation’s unemployment rate increased from3 to 8 percent. But things would have been far worse had it not been forJ.P. Morgan’s wisdom and forceful leadership. Morgan, together with afew banking colleagues and Treasury officials, had essentially performedthe most fundamental role of a central bank—serving as a lender of lastresort to the financial system in times of panic. However, it was apparentto thoughtful observers that it would be foolish for the young nation tocontinue to rely on the wisdom and benevolence of a single individual forits economic health, especially when that individual may not be entirelyfree of conflicts of interest. Clearly, the time was at hand to establish acentral bank.
110 T he p anic c ontributed appreciably t o the recession that e xtended from May 1907 to June In this period, national output declinedby about 10 percent and the nation’s unemployment rate increased from3 to 8 percent. But things would have been far worse had it not been forJ.P. Morgan’s wisdom and forceful leadership. Morgan, together with afew banking colleagues and Treasury officials, had essentially performedthe most fundamental role of a central bank—serving as a lender of lastresort to thul observers that it would be foolish for the young nation tocontinue to rely on the wisdom and benevolence of a single individual forits economic hee financial system in times of panic. However, it was apparentto thoughtfalth, especially when that individual may not be entirelyfree of conflicts of interest. Clearly, the time was at hand to establish acentral bank.Congress passed the Federal Reserve Act. President Woodrow Wilsonsigned the legislation the same day. After more than 135 years in existence,the United States now had a permanent central bank. However, asthe nation learned fewer than 20 years later, creation of the new centralbank by no means put an end to severe banking crises. Indeed, the mostsevere financial crisis in U.S. history was to occur during 1929–1933.
111 HEALTH INSURANCESometimes it seems as if there could be nothing mo catastrophic than losing a home or a family heirloom,but there is. Keeping yourself and your loved ones safeand healthy is the most important thing in the world. Yetserious illnesses, injuries, and even death occur to everyoneat some point. The only thing worse than having aserious health problem is having it without the properinsurance coverage in place. If you suffer an injury andyou aren’t prepared, your financial health can bedestroyed in an instant.
112 Most people are able to get the health insurance they need through their jobs. Lucky for them! But many people have to buy their ownhealth insurance, for a variety of reasons (for example, they’re self-employed,they work for a small company that doesn’t provide health insurance, theyretired before the age of 65, and so on).
113 An excellent health insurance plan must include five key ingredients: ✓ A coverage limit high enough that it won’t likely ever be exhausted,even for the most catastrophic medical expenses.✓ An annual dollar limit you can live with on your out-of-pocket maximum.(The out-of-pocket maximum is an important feature of healthinsurance policies that limits your annual responsibility for your healthinsurance policy copayments and deductibles.)✓ No dollar limits on types of expenses, such as dollar limits on dailyroom charges or dollar limits for types of surgical procedures.✓ Freedom to see specialists without a referral.✓ Worldwide coverage.Do most plans meet all five criteria? Nope. I estimate that less than half of theindividual and group health plans sold in the United States include all five elementsthat make a great health insurance plan.Why do these five elements matter? Because you want a plan that won’t,even in the worst case, cause you major financial hardship — and a plan thatlets you choose the most skilled care provider, especially in serious or lifethreateningsituations, such as treating your 6-year-old’s leukemia, surgicallyremoving your spouse’s brain tumor, or performing skin grafting operationsafter you’ve been badly burned.
114 Policy limits come in two varieties: ✓ A dollar maximum per claim: The per-claim maximum is the most theinsurance company will spend for any single illness or injury. If yourlimit is $1 million, for example, your policy will pay up to $1 millionfor your injuries in a recent car accident, and then up to another millionfor next year’s cancer, and another million for the following year’sParkinson’s disease.A dollar maximum per lifetime: Lifetime limits, where every dollarspent this year reduces the limit available for future years, are morecommon. If your lifetime limit is $1 million, your $225,000 car accidentbill reduces your lifetime limit to $775,000. Then your $150,000 cancerbill reduces the $775,000 lifetime limit to $625,000, and so on.When buying health insurance, I strongly recommend a maximum policy limitof at least $1 million per claim or $3 million per lifetime (or a policy with nolimits at all, if you can find one).
115 Capping your out-of-pocket costs Most health insurance plans require some kind of copayment on your part.(A copayment is the dollar amount your policy requires you to pay towardyour bills.) You may have a copay per visit (such as $25 for each office visitor $75 if you go to the emergency room). Perhaps you have a deductible of$500 a year before your coverage kicks in (meaning that you pay the first$500 of your medical expenses each year). Or maybe your policy pays 80percent of all covered medical bills, with you responsible for the other 20percent.Paying the per-visit copays or the deductible usually isn’t a hardship. Butpaying 20 percent of all your major medical bills in one year, without anylimit on the possible amount of your contribution, can be. If you have a babywho’s born three months premature and who needs pediatric intensive carefor a long time, your bill could run $400,000 — and your 20 percent copaywould be $80,000! If your baby needs surgeries, your bill could jump to$750,000, and your 20 percent copay would be $150,000! That’s too big a riskfor almost anyone to assume.Avoiding internal policy limitsA good health insurance policy has only one policy limit — either a limit perclaim or a limit per lifetime. It contains no other dollar limitations. Many mediocrepolicies contain internal limits such as $200 a day for room and board,$400 a day for intensive care, or dollar limits on specific surgeries ($4,000 foran appendectomy, $35,000 for quadruple bypass surgery, and so on).Even if the limits are adequate today (and most aren’t), in four to five years,given the rapid pace of medical cost inflation, you may end up getting onlyhalf your bill paid.Avoid like the plague any health insurance policy that contains internal policylimits on room and board, surgeries, or anything else.
116 Capping your out-of-pocket costs Most health insurance plans require some kind of copayment on your part.(A copayment is the dollar amount your policy requires you to pay towardyour bills.) You may have a copay per visit (such as $25 for each office visitor $75 if you go to the emergency room). Perhaps you have a deductible of$500 a year before your coverage kicks in (meaning that you pay the first$500 of your medical expenses each year). Or maybe your policy pays 80percent of all covered medical bills, with you responsible for the other 20percent.Paying the per-visit copays or the deductible usually isn’t a hardship. Butpaying 20 percent of all your major medical bills in one year, without anylimit on the possible amount of your contribution, can be. If you have a babywho’s born three months premature and who needs pediatric intensive carefor a long time, your bill could run $400,000 — and your 20 percent copaywould be $80,000! If your baby needs surgeries, your bill could jump to$750,000, and your 20 percent copay would be $150,000! That’s too big a riskfor almost anyone to assume.Avoiding internal policy limitsA good health insurance policy has only one policy limit — either a limit perclaim or a limit per lifetime. It contains no other dollar limitations. Many mediocrepolicies contain internal limits such as $200 a day for room and board,$400 a day for intensive care, or dollar limits on specific surgeries ($4,000 foran appendectomy, $35,000 for quadruple bypass surgery, and so on).Even if the limits are adequate today (and most aren’t), in four to five years,given the rapid pace of medical cost inflation, you may end up getting onlyhalf your bill paid.Avoid like the plague any health insurance policy that contains internal policylimits on room and board, surgeries, or anything else.
117 Making sure you don’t have to beg to see specialistsMany healthcare plans (such as many HMOs or PPOs) offer lower costs buttake away your right to decide what kind of treatment you can get and whomyou can get it from:✓ Usually, you agree to get all your primary care from a small list ofapproved clinics where costs can be controlled more easily.✓ You agree to seeing a specialist only if your primary physician will referyou out (which means “referral begging” to you).✓ You agree to give the insurance company the final say on what type ofprocedure or treatment you can have.That’s a lot to give up for a savings of about 15 percent on your premiums.If your employer-provided group plan doesn’t offer choice, you can buy anindividual major medical policy with a moderately high deductible. If youdon’t like your choices under managed care, you go see whomever you wantand pay just your deductible.Managed care worth consideringIn recent years, a managed care hybrid planhas emerged. It’s a two-tiered system. Thefirst tier is managed care. When you go to yourchosen primary doctor, you get almost 100 percentcoverage — even if you see a specialist,if it’s a referral from your primary doctor. Thesecond tier is freedom of choice: You can go toalmost anyone — any specialist — no referralsneeded. You just have to chip in on the extracost (for example, a $300 deductible, plus 20percent of the bill). When something serious isgoing on, the extra out-of-pocket expenses forthe freedom of choice are worth every penny
118 Ensuring that you’re covered away from homeMany managed care plans don’t cover you outside your home territory,except for emergencies. Here are two stories from my own client files:✓ Lee just bought a winter vacation condo in Arizona. (Why anyone wouldwant to flee Minnesota’s winter wonderland of ice, snow, and subzerotemperatures is beyond me.) Checking the Medicare supplement policyhe owned from a local HMO, he discovered that there was no coveragefor anything but emergency care outside Minnesota — a real problemfor someone living five months of each year outside the state. Luckily,we moved his coverage to another Medicare supplement policy thatgave him greater freedom of choice before anything serious happened.✓ Jim and Jane’s daughter, Angela, was attending college out east. Shefell and injured a knee. The emergency care was covered by their HMOpolicy, but follow-up care with physical therapists was not covered atall. It turns out that their otherwise excellent insurance has one majorflaw: For anyone residing out-of-state part of the year, nonemergencycare isn’t covered!
119 Saving Money on Individual Coverage You can cut costs on individual plans in three ways:✓ You can reduce your coverage and the insurance company will give youa direct premium credit.✓ You can put money into a health savings account (HSA) combined withan approved high-deductible health plan (HDHP). A HDHP is a highdeductiblemajor medical policy that meets the requirements of the IRSfor use in conjunction with an HSA. (See “Saving with health savingsaccounts,” later in this chapter, for more information).✓ You can opt for a higher deductible when your health and self-care areexceptional but when the insurance company has no way of loweringyour premiums.Changing your coverageYou can save money on your insurance by cutting out unneeded coverage.For example, if your individual policy currently includes coverage for maternity,and you know you’re not going to need it, you can drop that coverageand save money on your insurance premium.You can also cut back on doctor choice — by switching to an HMO from aPPO, for example.Socking away money in ahealth savings accountAn HSA operates like an individual retirement account (IRA) coordinatedwith an IRS-approved high-deductible major medical health insurance plan(HDHP). The big advantage of an HSA is that it allows you to pay for yourmajor medical deductible as well as elective medical and dental expenseswith pretax dollars. For most people, that’s equal to a 25 percent to 30 percentsavings on their medical and dental bills!
120 Here’s how an HSA works: ✓ As with an IRA, contributions are income tax deductible.✓ Earnings on the account are tax sheltered.✓ The maximum contribution per year is set annually by the government.For each person age 55 and older, an additional “catch-up” contributionis allowed. To find out what the current allowable amountsare, as well as anything else you want to know about health savingsaccounts, go to and click on the Health SavingsAccount link.✓ In order for the HSA contributions to be tax-deductible, you must alsohave an IRS-approved high-deductible health plan (HDHP). The HDHPmust include options for a minimum deductible and a maximum deductibleset by the government each year. There usually is a cumulative familydeductible amount for policies insuring two or more people in the family.There is no coverage under the policy until the entire family reaches thefamily deductible in a calendar year. (Be careful when choosing yourfamily deductible!) There generally is an option for 80 percent coverageas well as 100 percent coverage after the deductible is satisfied.Choose the 100 percent option. After you’ve satisfied the high deductiblein a calendar year, you’ll have peace of mind knowing that all coveredexpenses will be 100 percent paid, for the rest of the year.✓ From the HSA, you can pay your deductibles and most other medicaland dental expenses that your health plan doesn’t cover (such as lasereye surgery, glasses, contact lenses, hearing aids, and dental work).
121 Because the HSA money has never been taxed, you’re paying those bills with pretax dollars — a huge advantage.✓ If you’ve stayed reasonably healthy, you can leave unused funds ondeposit and either use them in future years or save them as supplementalretirement dollars. If you don’t use them for medical bills, withdrawalsare taxed much like traditional IRAs when you do retire.You can set up an HSA wherever you can establish an IRA — banks, savingsand loans, investment houses, insurance companies, and so on. Becauseof the need to write checks to pay doctors and buy prescription drugs, I’vefound that banks work best — that way, you can have an account with bothchecks and a debit card.✓ Don’t pay any medical bill or pharmacy charge until your insurancecompany has reduced the cost to its negotiated discount pricing.✓ Fund the account early in the year so you have plenty of cash available ifmedical bills are sizable in the first quarter of the year.✓ Keep all your receipts for all services you’ve paid through your HSA(medical bills, pharmaceutical bills, dental bills, and so forth) in a medicalfolder in case you ever get audited. For a complete and current listof IRS-approved medical and dental expenses, go to andsearch for Publication 502, or call to have it mailed to you.)Taking care of yourself and optingfor higher deductibles
122 The best way to save money on an individual policy, without cutting back on coverage, is to quit smoking. Unlike group policies, almost all individual policiesdifferentiate smokers from nonsmokers — significantly — because theclaims costs for smokers are much higher.Insurance companies don’t offer individual health insurance to people whoare high-risk medically. So, everyone else — from the super-fit and superhealthyto the average or below-average health risk — pays the same rateand shares the losses.If you’re healthy and take good care of yourself (through exercise, diet, stressmanagement, rest, and personal safety), how can you get credit if insurancecompanies don’t offer any? The answer: Opt for higher deductibles.The difference in cost between a $300 deductible and a $1,000 deductiblewith some insurers is a whopping 45 percent! As the size of your family orage increases, that 45 percent can save you a fortune — especially when youconsider that you’re assuming only $700 more risk per person each year.If you’re paying $4,000 a year for just yourself, 45 percent would save you$1,800 in premiums!Pricing for each level of deductible is based on average risk. If you’re muchfitter and healthier than average, you’re paying more than your share, nomatter what level of coverage you buy. But the higher your deductibles, themore you’ll save. Being above average in terms of health,
123 WHEN YOU CAN'T GET INSURANCE you’re willing to take one or more of the following actions, you can prevent afinancial catastrophe from happening to you because of an uninsured familymember:✓ If your employer doesn’t offer group coverage, talk to them aboutstarting to offer a group plan. Enlist the support of your coworkers.The Health Insurance Portability and Accountability Act of 1996 (HIPAA)requires insurance companies to accept all members of a group, regardlessof health. If your employer adds group health insurance coverage,the worst-case scenario is that the condition won’t be covered for thefirst 12 months. (See Chapter 19 for more information on preexistingconditions.)✓ Change employers. Get a job with a company that offers group medicalcoverage to its employees and their families.✓ If you’re in a state that has a major medical insurance plan for uninsurablepeople, sign up immediately. Call your state insurance departmentto find out.✓ Move to a state that offers catastrophic individual major medical coveragefor uninsurable citizens. Minnesota, where I live, has such a plan,and so do many other states.
124 When you’re brokeIf you’re in a financial crisis — temporary or permanent — and you just don’thave enough money available for health insurance, you can still protect yourselfsomewhat by managing your medical risks in advance.If you don’t develop a game plan for handling medical costs before you’refaced with them, you may end up being personally responsible for the entirecost of any emergency care that you need.Look into various assistance programs in which medical care is providedeither at no cost or at a nominal cost. In my community, for example, programsare available through Lutheran Social Services or Catholic Charities.In exchange for a very small amount of money per month, all family membersreceive the medical care they need. Participants are limited to designatedmedical facilities, but they get medical care now, without facing a huge debtlater. Also check in your area for free clinics.If you or a family member is in economic distress, research what’s available inyour community now and have an emergency plan so that you know whereyou’re going for care if and when you need it. A medical emergency isn’t thetime to figure out what your options are.
125 GROUP COVERAGEThe good news about group health insurance is that somebody else ispaying part of the premium. The bad news is that your plan choices aresomewhat restricted, and the coverage stays with the job when you leave.In this chapter, I help you make good choices about group health insurancewhile you’re employed and offer my recommendations about continuing yourcoverage after you leave.Choosing between two or more plansI often get calls from clients who want help choosing among group insuranceoptions offered to them at work. Having multiple options is especiallycommon with large employers or the government. If your employer offersmore than one group health insurance option, I recommend that you do thefollowing:✓ Consider price last. The only exception to this rule is if your financesare in poor condition. Otherwise, set aside cost for now.✓ Look at the five ingredients of a good health insurance plan and see how the insurance options you have to choosefrom compare. With any luck, at least one of the available plans includesall five ingredients. If it does, take that one.If two or more plans include all five ingredients, choose the one that alsohas paperless claims (meaning the doctors and hospitals file the claimsdirectly to the insurance company). If two or more plans also offerpaperless claims, then, and only then, decide on price.
126 Suppose your employer offers these three choices for group health plans for your family of four:✓ Option A is a true freedom-of-choice plan where you can go anywhereyou want for care. The only drawback is that you have to file your ownclaims. Your monthly cost is $750.✓ Option B is a limited-choice managed-care plan. It meets only one of thefive key criteria of a good plan — it has a limit on annual out-of-pocketexpenses. Its only advantage is low cost — $475 per month.✓ Option C is a hybrid of A and B. You can get care anywhere without areferral. Its only drawback is that if you go outside the rather substantialprimary-care network (86 percent of the doctors in the state), you’ll facea $300 deductible and probably will have to file your own claim. Yourcost is $650 per month.
127 If these were your choices, you’d choose Option B only if, due to poor finances, price was all-important. It meets only one of the five criteria of agood plan.You’d choose Option A if access to any doctor anywhere was worth the extra$1,200 a year and you could stand to file your own claims.Personally, I would choose Option C. (In fact, these were my choices, and Idid choose C.) It meets all five criteria of a good plan, and claims are paperless.I’m comfortable with the doctors who are available to me, and I canactually go to any other doctor if I’m okay with higher copays and filing myown claims.To help you make a good decision, if you’re still unclear about what choice tomake, consider spending $100 to $200 to consult with a good insurance agentyou know who is an expert on health insurance — maybe the agent whohelped you with your life insurance. Bring in your group insuranceContinuing Coverage When (COBRA)You Leave Your JobSince 1985, the federal government has taken steps to allow employees anddependents to continue their health insurance when they would otherwisehave lost it due to terminated employment, divorce, or other life events. Thegovernment’s goal has been to try to make group health insurance portable,especially for those whose medical history would not allow them to qualifyfor individual health policies. In this section, I fill you in on two federal lawsthat may give you some insurance continuation rights when you lose yourgroup health coverage, and I offer advice on when to exercise those rights
128 OTHER GOVERNMENT PROGRAMS HIPAA: For When COBRA EndsThe Health Insurance Portability and Accountability Act (HIPAA) was createdto give people who are losing their group coverage and who have preexistingmedical conditions the right to continued health coverage without preexisting-condition exclusions applying to their replacement policy. The intent ofthe law is to prevent “job lock,” where an employee is stuck in a dead-end jobin order to keep the health coverage, because he or a family member has apreexisting medical condition (defined by HIPAA as any condition treated bydoctors or medication in the last six months). HIPAA makes it possible for anemployee leave a job and take a new job with group medical coverage, withthe assurance that the health issues of everyone in the family are immediatelycovered under the new group policy. HIPAA also makes it possible foran individual to leave the group policy and buy a private policy without preexisting-condition limitations or having to qualify medically, providing thatyour COBRA option, if any, has been exercised and the time frame exhausted(in other words, you’ve stuck with COBRA as long as it was available to you).The federal government has left it up to each state to determine exactly whattype of individual health product is made available. The only condition is thatthere can be no preexisting condition waiting period or exclusion — preexistingconditions have to be covered immediately, provided that everyone beingcovered has had consecutive coverage for the past 12 months with no lapsein coverage of more than 63 days.
129 Social Security Long-Term Disability When you think Social Security, you probably think retirement program. Youmay think survivor benefits for children. But few people realize that SocialSecurity also includes disability benefits that start after 5 months of totaldisability if that disability is expected to last 12 months or more or result indeath. Benefits are payable to your normal retirement age.If you’ve been paying into the Social Security system, every year you get astatement of estimated benefits. That statement includes your estimatedretirement benefits, as well as your estimated long-term disability benefits.Don’t rely strictly on Social Security to meet your need for income replacementfollowing a disability. In fact, I generally recommend that you ignoreSocial Security so that, if you do qualify for benefits, they’ll be a little extracushion for youState Health Insurance PoolsWhenever you apply for an individual health policy, there are four possibleoutcomes:✓ Your application is approved.✓ Your application is denied.✓ Your application is approved at higher rates because of preexisting conditions(such as diabetes).
130 ✓ Your application is approved, but an exclusionary rider is attached to the policy excluding coverage for a preexisting condition (such as a badback, bad knees, and so on).Many states have created health insurance pools that ensure people withpreexisting health conditions who can’t get health insurance or can’t get itwithout surcharged pricing or exclusionary riders.If you or a family member is facing that predicament, check with your stateinsurance department to see if your state has such a pool. Or go online to theNational Association of State Health Insurance Plans atMedicaidBacked by the federal government and administered by the states, Medicaidis a health insurance program that provides medical assistance to those inneed — people at or near poverty levels. Medicaid also provides long-termcare for those with little or no assets. It is of particular interest to middleclassAmericans who need long-term care but don’t have insurance coveragefor that. In that case, they end up spending down all their assets to nearpoverty levels, at which point Medicaid will pick up the costs of any ongoingcare for the rest of their lives. The tragedy is that, by spending down all yourassets, little (if anything) is left for your surviving spouse or children.
131 MEDICARE: Otherwise known as national health insurance for seniors, Medicare provides a base level of hospital and medical benefits. In 2003, optional prescriptiondrug coverage (known as Part D) was added. Medicare is funded by acombination of premium payments from seniors and payroll taxes from nonseniors.In addition to the three parts of Medicare — Part A (hospital), PartB (medical), and Part D (drugs) — most seniors will want a good Medicaresupplement policy to pay most of what Medicare doesn’t cover or disallow.For more information on Medicare, go togov.
132 MORTGAGESBuying a home is the embodiment of the American dream. However, that wasn’t always the case: In fact, before the 1930s, only four in 10 American families owned their own home. That’s because very few people had enough cash to buy a home in one lump sum. And until the 1930s, there was no such thing as a bank loan specifically designed to purchase a home, something we now know as a mortgage.In simple terms, a mortgage is a loan in which your house functions as the collateral. The bank or mortgage lender loans you a large chunk of money (typically 80 percent of the price of the home), which you must pay back -- with interest -- over a set period of time. If you fail to pay back the loan, the lender can take your home through a legal process known as foreclosure.For decades, the only type of mortgage available was a fixed-interest loan repaid over 30 years. It offers the stability of regular -- and relatively low -- monthly payments. In the 1980s came adjustable rate mortgages (ARMs), loans with an even lower initial interest rate that adjusts or “resets” every year for the life of the mortgage. At the peak of the recent housing boom, when lenders were trying to squeeze even unqualified borrowers into a mortgage, they began offering “creative” ARMs with shorter reset periods, tantalizingly low “teaser” rates and no limits on rate increases.When you couple bad loans with a bad economy, you get rampant foreclosures. Since 2007, more than 250,000 Americans have entered foreclosure proceedings every month [source: Levy]. Now those foreclosures are turning into full-on repossessions, which are expected to reach 1 million homes in 2010 [source: Veiga].Looking back at the flood of foreclosures since the housing crash, it’s clear that many borrowers didn't fully understand the terms of the mortgages they signed. According to one study, 35 percent of ARM borrowers did not know if there was a cap on how much their interest rate could rise [source: Pence]. This is why it’s essential to understand the terms of your mortgage, particularly the pitfalls of “nontraditional” loans.
133 In legal terms, a mortgage is "the pledging of property to a creditor as security for the payment of a debt" [source: YourDictionary.com]. In plain English, a mortgage is a loan. For many people, it's the biggest loan they will ever borrow. With a regular loan, there's no explicit collateral. The lender looks at your credit history, your income and your savings, and determines if you're a good risk. With a mortgage, the collateral for the loan is the house itself. If you don't pay back the loan (along with all of the fees and interest that are included with it), then the lender can take your house.Banks are the traditional mortgage lender. You can either apply for a mortgage at the bank you use for your checking and savings accounts, or you can shop around to other banks for the best interest rates and terms. If you don't have the time to shop around yourself, you can work with a mortgage broker, who sifts though different lenders to negotiate the best deal for you. Banks aren't the only source of mortgages, though: Credit unions, some pension funds and various government agencies also offer mortgages.Like other loans, mortgages carry an interest rate, either fixed or adjustable, and a length or "term" of the loan, anywhere from five to 30 years. Unlike most other loans, mortgages carry a lot of associated costs and fees. Some of those fees only happen once, such as closing costs, while others are tacked onto the mortgage payment every month.
134 It was only in the 1930s, however, that mortgages actually got their start. It may surprise you to learn that banks didn't forge ahead with this new idea; insurance companies did. These daring insurance companies did this not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if borrowers failed to keep up with the payments.It wasn't until 1934 that modern mortgages came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of the Great Depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent -- not the amount you financed! With loan terms like that, it's no wonder that most Americans were renters.FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes.The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply "knowing someone." The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today.Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn't want the loan outlasting the building! This started another trend that commercial lenders eventually followed.Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan's principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.
135 the Mortgage PaymentThe down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price, but it's possible to find mortgages that require as little as 3 to 5 percent. The more money you put down, though, the less you have to finance -- and the lower your monthly payment will be.The monthly mortgage payment is composed of the following costs, appropriately known by the acronym PITI:Principal - The total amount of money you are borrowing from the lender (after your down payment)Interest - The money the lender charges you for the loan. It's a percentage of the total amount of money you're borrowing.Taxes - Money to pay your property taxes is often put into an escrow account, a third-party entity that holds accumulated property taxes until they're due.Insurance - Most mortgages require the purchase of hazard insurance to protect against losses from fire, storms, theft, floods and other potential catastrophes. If you own less than 20 percent of the equity in your home, you may also have to buy private mortgage insurance, which we'll talk more about later.With a fixed-rate mortgage, your monthly payment remains roughly the same for the life of the loan. What changes from month to month and year to year is the portion of the mortgage payment that pays down the principal of the loan and the portion that is pure interest. The gradual repayment of both the original loan and the accumulated interest is called amortization.If you look at the amortization schedule for a typical 30-year mortgage, the borrower pays much more interest than principal in the early years of the loan. For example, a $100,000 loan with a 6 percent interest rate carries a monthly mortgage payment of $599. During the first year of mortgage payments, roughly $500 each month goes to paying off the interest; only $99 chips away at the principal. Not until year 18 does the principal payment exceed the interest.The advantage of amortization is that you can slowly pay back the interest on the loan, rather than paying one huge balloon payment at the end. The downside of spreading the payments over 30 years is that you end up paying $215,838 for that original $100,000 loan. Also, it takes you longer to build up equity in the home, since you pay back so little principal for so long. Equity is the value of your home minus your remaining principal balance.But that doesn't mean that fixed-rate, 30-year mortgages are a bad thing. Far from it.
136 Fixed-rate MortgagesNot that long ago, there was only one type of mortgage offered by lenders: the 30-year, fixed-rate mortgage. A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 15, 20 or 30 years, depending on the length of your mortgage. The only numbers that might change are property taxes and any insurance payments included in your monthly bill.The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20 and 15-year terms:30-year fixed-rate -- Since this is the longest loan, you'll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments.20-year fixed-rate -- These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you'll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage.15-year fixed-rate -- This loan term has the same benefits as the 20-year term (quicker payoff, higher equity and lower interest rate), but you'll have an even higher monthly payment.There is a long-term stability to fixed-rate mortgages that many borrowers find attractive-- especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgages,
137 Adjustable-rate Mortgages An adjustable-rate mortgage (ARM) has an interest rate that changes -- usually once a year -- according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage. Even in 2010, with interest rates on the 30-year fixed mortgage at historic lows, the ARM rate is almost a full percentage point lower [source: Haviv]. ARMs also make sense to borrowers who believe they'll be selling their home within a few years.If you're considering an ARM, one important thing to remember is that intentions don't always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a "reset" mortgage they couldn't afford. Many of them never fully understood the terms of their ARM agreement. Here are the key numbers to look for:How often your interest rate adjusts -- A conventional ARM adjusts every year, but there are also six-month ARMs, one-year ARMs, two-year ARMs and so on. A popular "hybrid" ARM is the 5/1 year ARM, which carries a fixed rate for five years, then adjusts annually for the life of the loan. A 3/3 year ARM has a fixed rate for the first three years, then adjusts every three years.There will also be caps, or limits, to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment and lifetime caps specify how high the rate can go over the life of the loan. Never sign up for an ARM without any caps!The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR) or other indexes. When mortgage lenders come up with their ARM rates, they look at the index and add a margin of two to four percentage points. Being tied to these index rates means that when those rates go up, your interest goes up with it. The catch? If interest rates go down, the rate on your ARMs may not [source: Federal Reserve]. In other words, read the fine print.
138 Other Types of Mortgages Let's start with a risky type of mortgage called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that's amortized as if it's a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but here's the kicker. At the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This "balloon" payment can be a killer. If you can't flip or refinance the home in five years, you're out of luck.Reverse mortgages actually pay you as long as you live in your home. These loans are designed for homeowners age 62 and older who need an inflow of cash, either as a monthly check or a line of credit. Essentially, these homeowners borrow against the equity in their homes, but they don't have to pay the loan back as long as they don't sell their homes or move. The downside is that the closing costs can be very high, and you still have to pay taxes and mortgage insurance [source: Moore].Three agencies of the federal government work with lenders to offer discounted rates and loan terms for qualifying borrowers: Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development, the Veterans Administration (VA) and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture.These agencies don't directly lend money to borrowers. Rather, they insure the loans made by approved mortgage lenders. This includes the refinancing of mortgages that have become unaffordable. Borrowers with bad credit histories might find it easier to secure a loan from an FHA-approved lender, since the lender knows that if the borrower fails to pay back the loan, the government will pick up the bill. FHA loans only require a 3 percent down payment, all of which can come from a family member, employer or charitable organization [source: HUD]. Commercial mortgages wouldn't allow that.Veterans Administration loans, like FHA loans, are guaranteed by the agency, not lent directly to borrowers.VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Vets can pay no money down as long as the home price doesn't exceed the loan limits for the county.If you live in a rural area or small town, you may qualify for a low-interest loan through the Rural Housing Service. RHS offers both guaranteed loans through approved lenders and direct loans that are government funded. Theyenable low-income families to get loans for homes.
139 Understanding APRProbably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it's hard to compare apples to apples when comparing mortgages. Sometimes it seems like we're comparing apples to grapefruits.For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there's a way to do that. Lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars.The annual percentage rate (APR) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate -- hence the name. The APR will be slightly higher than the interest rate the lender is charging because it includes all (or most) of the other fees that the loan carries with it, such as the origination fee, points and PMI premiums.Here's an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn't. Fortunately, the APR considers all of the fine print.Say you need to borrow $100,000. With either lender, that means that your monthly payment is $ If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 - $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $ for a loan of $97,975. In this case, it's really 7.2 percent.
140 The Origination FeeThe origination fee is how lenders make money up front on your mortgage loan. Origination fees are calculated as a percentage of the total loan, usually between 0.5 and 1 percent on U.S. mortgages [source: Investopedia]. Going back to our APR example, let's say that the second lender charges a 3 percent origination fee, plus an application fee and other costs totaling $3,820 at closing. That brings the new loan amount down to $96,180, which yields an APR of 7.39 percent. So there you have it: Although the second lender advertised no points, it ended up with a higher APR because of its steep origination fee.The take home message is simple: Don't just look at the interest rate. Ask for the APR and compare it with other lenders. Also, make sure you know which fees are being included in the APR calculation. Typically, these include origination fees, points, buydown fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. But note that some fees are charged by all lenders and are non-negotiable, such as title insurance and appraisals.Luckily, you don't have to calculate the APR on your own. The lender will give it to you when it gives you the Federal Truth in Lending Disclosure; you just have to understand its importance.Here are some other things to take into account when you examine the APR:The more you borrow, the less impact all of those fees will have on the APR, since the APR is calculated based on the total loan amount.The length of time you're actually in the home before you sell or refinance directly influences the effective interest rate you ultimately get. For example, if you move or refinance after three years instead of 30, after having paid two points at the loan closing, your effective interest rate for the loan is much higher than if you stay for the full loan term.
141 Qualifying for a LoanIn order to qualify for a mortgage, most lenders require that you have a debt-to-income ratio of 28/36 (this can vary depending on the down payment and the type of loan you're getting, however). This means that no more than 28 percent of your total monthly income (from all sources and before taxes) can go toward housing, and no more than 36 percent of your monthly income can go toward your total monthly debt (this includes your mortgage payment). The debt they look at includes any longer-term loans like car loans, student loans, credit cards or any other debts that will take a while to pay off.Here's an example of how the debt-to-income ratio works: Suppose you earn $35,000 per year and are looking at a house that would require a mortgage of $800 per month. According to the 28 percent limit for your housing, you could afford a payment of $816 per month, so the $800 per month this house will cost is fine (27 percent of your gross income). Suppose, however, you also have a $200 monthly car payment and a $115 monthly student loan payment. You have to add those to the $800 mortgage to find out your total debt. These total $1,115, which is roughly 38 percent of your gross income. That makes your housing-to-debt ratio 27/38. Lenders typically use the lesser of the two numbers, in this case the 28 percent $816 limit, but you may have to come up with a bigger down payment or negotiate with the lender.You also have to think about what you can afford. The lender will tell you what you can afford based on the lower number in the debt-to-income ratio, but that's not taking any of your regular expenses (like food) into account. What if you have an expensive hobby or have plans for something that will require a lot of money in five years? Your lender doesn't know about that, so the $1,400 mortgage it says you qualify for today may not fit your actual budget in five years -- particularly if you don't see your income increasing too much over that period. Take a look at this calculator to see how much house you can afford based on your current income.In general, it's more difficult to qualify for a mortgage now than it was during the housing boom, when just about any motivated homebuyer could find credit -- even many who couldn't afford to buy a house.
142 Mortgage ApplicationA lender will look at your employment history and credit history as indicators of how likely you are to pay back your loan. Lenders want to see stability, which means they will look closely any late payments during the last two years of your credit history. They will pay particular attention to any rent or mortgage payments that were more than 30 days past due. They'll also look at late payments for credit cards during the last six months.Stable income is also important. Lenders look for steady employment with a single employer for the past two years (or at least employment in the same field). Other income -- such as earnings from part-time or freelance work, overtime, bonuses or self-employment -- is also acceptable if it has a two-year history. If you don't meet the minimum requirements, that doesn't mean you'll never quality for a mortgage. You may just have to talk to more lenders or settle for a higher interest rate.The entire credit market has been tight for several years now. Mortgage lenders give the best interest rates to borrowers with high credit scores (760 to 850) who can make a big down payment (10 to 20 percent) [source: Esswein].Here is a typical list of the documents you need when applying for a mortgage:Money for the closing costsCompleted sales contract signed by buyers and sellersSocial Security numbers of all applicantsComplete address for the past two years (including complete name and address of landlords for past 24 months)Names, addresses and all income earned from all employers for past 24 monthsW-2 forms for the two years prior to your loan applicationMost recent pay stub showing year-to-date earningsNames, addresses, account numbers, monthly payments and current balances for all loans and charge accountsNames, addresses, account numbers and balances for all deposit accounts, such as checking accounts, savings accounts, stocks and bondsThe last three statements for deposit accounts, stocks and bondsIf you choose to include income from child support and/or alimony, bring copies of court records of cancelled checks showing receipt of payment.A more detailed list can be found here. Your lender and closing attorney will also tell you what paperwork and documents you will need to present at the loan closing.
143 What Are Closing Costs?The total cost of a home mortgage is much more than just the monthly mortgage payments. Once a sales contract is signed, the closing process begins. As part of the closing, the deed and title are transferred to the buyer, title insurance and financing documents are exchanged and copies are delivered to the county recorder. Since the closing is a legal process, it often involves an attorney or at least a third-party escrow holder. All of these processes and professionals cost money, adding up to a surprisingly large sum known as the closing costs.The amount of money you'll have to pay in closing costs varies a lot by region. If you live in a highly taxed area, for example, your closing costs will be higher. Also, realtors, lenders and attorneys have differing fee scales depending on the markets they work in. Typically, you will pay anywhere from 3 to 6 percent of your total loan amount in closing costs -- that means $3,000 to $6,000 if you get a $100,000 loan.Of course, you can and should shop around and negotiate the fees. The Real Estate Settlement Procedures Act requires lenders to provide you with a good faith estimate of closing costs within three days of receiving your application. As you can see from the list covering the next few pages, there are a lot of fees that you might be able to convince the lender to lower or drop. You may also be able to negotiate for the seller to pay some of the closing costs.The fees for services involved in closing a mortgage fall into three categories: the actual cost of getting the loan, the fees involved in transferring ownership of the property and the taxes paid to state and local governments.
144 List of Closing Costs, Part I Here are some of the major fees included closing costs:Processing fee --This is what the lender charges to cover initial loan processing costs. It includes the application and credit report access fees. These charges are usually around $400 to $550. Something to watch for when comparing lenders: Sometimes the credit report fee will be listed separately from the processing fee.Appraisal fee -- Because the lender wants to make sure the property is worth what you are paying for it, it requires an appraisal. An appraisal compares the value of the property to similar properties in the same neighborhood. These services are performed by independent appraisers and usually cost around $250 or more depending on the price of the property.Origination fee -- In addition to the application or processing fee, the lender may also charge an origination fee. This covers the additional work the lender has to do when preparing your mortgage. The charge may be a flat fee or a percentage of the mortgage. If the fee is a percentage of the loan, then it is typically considered a "discount point" in disguise. This changes the tax implications and your costs, so be sure to ask the lender about this fee.Discount points -- Buying discount points means that you're buying "down" the interest rate you'll be paying. One discount point equals 1 percent of the loan amount. These points are paid either when the loan is approved or at closing. Buying points can save a lot of money in interest payments over the life of the loan, so investigate it when you're shopping around. Some lenders will let you add the cost of the points to your mortgage, or you may have the option of paying for them up front. You can also deduct those points from your federal income tax. For more information about what is tax deductible, click here.Document preparation fee -- This charge may be included in the application or attorney's fee. It pays for the preparation of the mound of documents that have to be prepared and is usually a flat rate, but can also be charged as a percentage of the loan amount -- usually less than 1 percent.
145 List of Closing Costs, Part II If you thought you were done with closing costs, think again:Attorney fees -- Both you and your lender will incur attorney fees. This charge ensures that your lawyer draws up the necessary documents and sets everything up properly for the closing. Your own closing attorney will represent your interests and may be present at, or may facilitate, the closing itself. The closing attorney collects all fees, transfers the deed to the buyer, pays outstanding taxes and utility bills, pays himself and all other closing costs and gives all remaining money to the seller. The attorney fees may range from $500 to $1,000 or more, depending on the purchase price of the property and the complexity of the sale.Home and pest inspections -- Your lender will probably require that the home be inspected to make sure it's both structurally sound and free of termites and other destructive insects. You may also have to have the water tested if the property uses a well rather than city tap water. In some areas, the water test means checking only the quantity of water available to the house, rather than the quality. If this is the case, you may want to have your own water quality test done.Homeowner's and hazard insurance -- You'll have to have these policies in place (and the first year's premium prepaid) at the time of the closing in most states. This insurance protects your (and the lender's) investment if the house is destroyed.Private mortgage insurance (PMI) -- If your down payment is less than 20 percent of the value of the house, you may be required to purchase mortgage insurance. This protects the lender in case you fail to make your mortgage payments. Premiums will usually be a part of your monthly mortgage payment and will be transferred into the same escrow account your taxes and homeowner's insurance fees are paid into. You have to pay these PMI premiums until you reach the 20 or 25 percent requirement -- or, they can go on for the life of the loan. (See the next section for more details on PMI.)Surveys -- Many lenders will require that the land be independently surveyed. This is just to ensure that there haven't been any changes, like new structures or encroachments on the property, since the last survey. These usually run $250 to $500.
146 List of Closing Costs, Part III Yes, there are more:Prepaid interest -- Although your first payment won't be due for six to eight weeks, the interest starts accruing the day you close the sale. The lender calculates the interest due for that fraction of a month before your first official mortgage payment. It's a good strategy to plan your closing for the end of the month to reduce the amount of prepaid interest you'll owe.Deed recording fees -- These fees, usually around $50, pay the county clerk to record the deed and mortgage and change the billing information for property taxes.Title search fees -- A title search ensures that the person saying he or she owns the property is the legitimate owner. A title company closely examines public records such as deeds, records of death, court judgments, liens, contests over wills and other documents that could affect ownership rights. This is an important step in closing your loan because it assures that there are no outside claims against the property. The fees charged for title searches, usually between $300 and $600, are based on a percentage of the property cost.Title insurance -- If the title company misses something during the title search, you'll be glad you have title insurance. Title insurance protects you from having to pay the mortgage on a property you no longer legally own. Lenders require title insurance to protect their investment, but you may also want to get your own policy. Title insurance has only a onetime fee that covers your property for the entire length of time you or your heirs own it (usually 0.2 to 0.5 percent of the loan amount for lender's title insurance, and 0.3 to 0.6 percent for owner's title insurance). It's also one of the least expensive types of insurance. If the previous owner of the property owned it for only a few years, you may be able to get title insurance at a "re-issue" rate, which is usually lower than the regular rate.Closing Taxes -- Depending on the state you live in, you will have to pay anywhere from three to eight (or more) months' taxes at the closing, or place the money in an escrow account for later payments throughout the year. These include prorated school taxes, municipal taxes and any other required taxes. In some cases, you may be able to split these taxes with the seller based on when they are due. For example, you would only pay taxes for the months following the closing date up until the date the taxes had to be paid. The seller would have to pay for the months up until the closing date.Now that you've finally closed the sale -- yes, you may actually have to pay for something else
147 Private Mortgage Insurance Private mortgage insurance (PMI) can help you snag the mortgage you want with a down payment of 20 percent or less. This is particularly helpful for younger buyers who haven't had the years to save but want to enjoy the tax benefits and investment aspects of home ownership. PMI is insurance that pays the mortgage in case you can't. It's protection for the lender, who is taking a greater risk with a borrower who has less equity. Lenders have discovered through experience and research that there is a definite correlation between the amount of money a borrower has put into the home and the rate of default on loans. The more equity in the home, the lower the rate of default.Here is an example of how it works: If a couple has $10,000 in the bank, then they can buy a $50,000 home if they have to pay a 20 percent down payment. If they don't have to pay 20 percent, then that same $10,000 can be a 10 percent down payment on a $100,000 house or a 5 percent down payment on a $200,000 house. If they opt for the more expensive house, however, they have to pay for PMI. The costs for PMI are based on the loan amount. For a $100,000 loan with a 10 percent down payment, the average cost of PMI might be $40 per month.In 1998, the Homeowners Protection Act established rules for mortgages signed on or after July 29, 1999, that require the automatic termination of PMI after you have reached 22 percent equity in the home, based on the original property value. You can also request that the PMI be dropped when you reach 20 percent if your mortgage was signed after that date. If your mortgage was signed prior to that date, you can request the cancellation of PMI once you've reached the magic 20 percent mark, but your lender isn't required by law to cancel it.There are certain conditions that may make your loan an exception to this rule -- for example, if you haven't kept your payments current, if your loan is considered high-risk or if you have other liens on the property. Note that there are some states that have laws regarding early termination of PMI for those who signed mortgages before July 29, 1998.
148 Private Mortgage Insurance Private mortgage insurance (PMI) can help you snag the mortgage you want with a down payment of 20 percent or less. This is particularly helpful for younger buyers who haven't had the years to save but want to enjoy the tax benefits and investment aspects of home ownership. PMI is insurance that pays the mortgage in case you can't. It's protection for the lender, who is taking a greater risk with a borrower who has less equity. Lenders have discovered through experience and research that there is a definite correlation between the amount of money a borrower has put into the home and the rate of default on loans. The more equity in the home, the lower the rate of default.Here is an example of how it works: If a couple has $10,000 in the bank, then they can buy a $50,000 home if they have to pay a 20 percent down payment. If they don't have to pay 20 percent, then that same $10,000 can be a 10 percent down payment on a $100,000 house or a 5 percent down payment on a $200,000 house. If they opt for the more expensive house, however, they have to pay for PMI. The costs for PMI are based on the loan amount. For a $100,000 loan with a 10 percent down payment, the average cost of PMI might be $40 per month.In 1998, the Homeowners Protection Act established rules for mortgages signed on or after July 29, 1999, that require the automatic termination of PMI after you have reached 22 percent equity in the home, based on the original property value. You can also request that the PMI be dropped when you reach 20 percent if your mortgage was signed after that date. If your mortgage was signed prior to that date, you can request the cancellation of PMI once you've reached the magic 20 percent mark, but your lender isn't required by law to cancel it.There are certain conditions that may make your loan an exception to this rule -- for example, if you haven't kept your payments current, if your loan is considered high-risk or if you have other liens on the property. Note that there are some states that have laws regarding early termination of PMI for those who signed mortgages before July 29, 1998.
149 PLAYING THE STOCK MARKET INSIDER ACTIVITY: Imagine that you’re boarding a cruise ship, ready to enjoy a hard-earnedvacation. As you merrily walk up the plank, you notice that the ship’scaptain and crew are charging out of the vessel, flailing their arms, andscreaming at the top of their lungs. Some are even jumping into the waterbelow. Quiz: Would you get on that ship? You get double credit if you canalso explain why (or why not).What does this scenario have to do with stock investing? Plenty. The behaviorof the people running the boat gives you important clues about the neartermprospects for the boat. Similarly, the actions of company insiders canprovide important clues into the near-term prospects for their company.Company insiders are key managers or investors in the company. Insidersinclude the president of the company, the treasurer, or another managingofficer. An insider can also be someone who owns a large stake in the companyor someone on the board of directors. In any case, insiders usually havea bird’s-eye view of what’s going on with the company and a good idea ofhow well (or how poorly) the company is doing.
150 Keep tabs on what insiders are doing, because their buy/sell transactions do have a strong correlation to the near-term movement of their company’sstock. However, don’t buy or sell stock only because you heard that someinsider did. Use the information on insider trading to confirm your own goodsense in buying or selling stock. Insider trading sometimes can be a great precursorto a significant move that you can profit from if you know what to lookfor. Many shrewd investors have made their profits (or avoided losses) bytracking the activity of the insiders.Tracking Insider TradingFortunately, we live in an age of disclosure. Insiders who buy or sell stockmust file reports that document their trading activity with the Securities andExchange Commission (SEC), which makes the documents available to thepublic. You can view these documents at either a regional SEC office (seeor on the SEC’s Web site, whichmaintains the EDGAR (Electronic Data Gathering, Analysis, and Retrieval)database (www.sec.gov/edgar.shtml). Just click on the “Search forCompany Filings” button. Some of the most useful documents you can viewthere include the following:✓ Form 3: This form is the initial statement that insiders provide. Theymust file Form 3 within ten days of obtaining insider status. An insiderfiles this report even if he hasn’t made a purchase yet; the report establishesthe insider’s status.
151 ✓ Form 4: This document shows the insider’s activity, such as a change in the insider’s position as stockholder — how many shares the personbought and sold or other relevant changes. Any activity in a particularmonth must be reported on Form 4 by the 10th of the following month.✓ Form 5: This annual report covers transactions that are small and notrequired on Form 4, such as minor, internal transfers of stock.✓ Form 144: This form serves as the public declaration by an insiderof the intention to sell restricted stock — stock that the insider wasawarded, or received from the company as compensation, or bought asa term of employment. Insiders must hold restricted stock for at leastone year before they can sell it. After an insider decides to sell, she filesForm 144 and then must sell within 90 days or submit a new Form 144.The insider must file the form on or before the stock’s sale date. Whenthe sale is finalized, the insider is then required to file Form 4.
152 Fighting accounting fraud: The Sarbanes-Oxley Act Very often, a market that reaches a mania stagesees abuse reach extreme conditions as well.Abuse by insiders is a good example. In thestock market mania of 1997–2000, this abusewasn’t just limited to insider buying and sellingof stock; it also covered the related abuse ofaccounting fraud. (Companies like Enron in 2001and Fannie Mae in 2008 come to mind.) The topmanagement executives at several prominentcompanies deceived investors about the companies’financial conditions and subsequentlywere able to increase the perceived value ofthe companies’ stock. The stock could thenbe sold at a price that was higher than marketvalue. Congress took notice of these activitiesand, in 2002, passed the Sarbanes-Oxley Act(SOX). Congress designed this act to protectinvestors from fraudulent accounting activitiesby corporations. SOX established a publicaccounting oversight board and also tightenedthe rules on corporate financial reporting.Since passage of SOX, the period of 2003–2007was relatively quiet on the corporate compliancefront, but as I write this, SOX will soon betested, as Wall Street’s financial institutionshave been slammed by bankruptcy and allegedmanagement wrongdoing.
153 Companies are required to make public the documents that track their trading activity. The SEC’s Web site offers limited access to these documents, but forgreater access, check out one of the many companies that report insider tradingdata, such as andThe SEC has enacted the short-swing profit rule to protect the investing public.This rule prevents insiders from quickly buying the stock that they just sold ata profit. The insider must wait at least six months before buying it again. TheSEC created this rule to prevent insiders from using their privileged knowledgeto make an unfair profit quickly, before the investing public can react.The rule also applies if an insider sells stock — he can’t sell it at a higher pricewithin a six-month period.Looking at Insider TransactionsThe classic phrase “Actions speak louder than words” was probably coinedfor insider trading. Insiders are in the know, and keeping a watchful eye ontheir transactions — both buying and selling their company’s stock — canprovide you with very useful investing information. But insider buying andinsider selling can be as different as day and night; insider buying is simple,while insider selling can be complicated. In the following sections, I presentboth sides of insider trading.
154 Breaking down insider buying Insider buying is usually an unambiguous signal about how an insider feelsabout his company. After all, the primary reason that all investors buy stockis that they expect it to do well. If one insider is buying stock, that’s generallynot a monumental event. But if several or more insiders are buying, thosepurchases should certainly catch your attention.Insider buying is generally a positive omen and beneficial for the stock’sprice. Also, when insiders buy stock, less stock is available to the public. Ifthe investing public meets this decreased supply with increased demand, thestock price rises. Keep these factors in mind when analyzing insider buying:✓ Identify who’s buying the stock. The CEO is buying 5,000 shares. Is thatreason enough for you to jump in? Maybe. After all, the CEO certainlyknows how well the company is doing. But what if that CEO is just startingher new position? What if before this purchase she had no stock inthe company at all? Maybe the stock is part of her employment package.The fact that a new company executive is making her first stock purchaseisn’t as strong a signal urging you to buy as the fact that a longtimeCEO is doubling her holdings. Also, if large numbers of insiders arebuying, that sends a stronger signal than if a single insider is buying.✓ See how much is being bought. In the preceding example, the CEObought 5,000 shares, which is a lot of stock no matter how you count it.But is it enough for you to base an investment decision on? Maybe, buta closer look may reveal more. If she already owned 1 million shares atthe time of the purchase, then buying 5,000 additional shares wouldn’t
155 be such an exciting indicator of a pending stock rise be such an exciting indicator of a pending stock rise. In this case, 5,000shares is a small incremental move that doesn’t offer much to getexcited about.However, what if this particular insider has owned only 5,000 sharesfor the past three years and is now buying 1 million shares? Now thatshould arouse your interest! Usually, a massive purchase tells you thatparticular insider has strong feelings about the company’s prospectsand that she’s making a huge increase in her share of stock ownership.Still, a purchase of 1 million shares by the CEO isn’t as strong a signalas ten insiders buying 100,000 shares each. Again, if only one person isbuying, that may or may not be a strong indication of an impending rise.However, if lots of people are buying, consider it a fantastic indication.An insider purchase of any kind is a positive sign, but it’s always moresignificant when a greater number of insiders are making purchases.“The more the merrier!” is a good rule for judging insider buying. Allthese individuals have their own, unique perspectives on the company
156 and its prospects. Mass buying indicates mass optimism for the company’s future. If the treasurer, the president, the vice president of sales,and several other key players are putting their wealth on the line andinvesting it in a company they know intimately, that’s a good sign foryour stock investment as well.✓ Notice the timing of the purchase. The timing of insider stock purchasesis important as well. If I tell you that five insiders bought stock atvarious points last year, you may say, “Hmm.” But if I tell you that all fivepeople bought substantial chunks of stock at the same time and rightbefore earnings season, that should make you say, “HMMMMM!”TEN WAYS TO PROFIT BEFORE THE CROWD DOES1. USE YOUR INSTINCTS2. TAKE NOTICE OF PRAISE FROM CONSUMER GROUPS3. CHECK OUT POWERFUL DEMOGRAPHICS4. LOOK FOR A RISE IN EARNINGS5. ANALYZE INDUSTRIES6. STAY AWARE OF POSITIVE PUBLICITY FOR INDUSTRIES7. STAY AWARE OF MEGATRENDS8. KEEP TRACK OF POLITICS9. RECOGNIZE HEAVY INSIDER OR CORPORATE BUYING10. FOLLOW INSTITUTIONAL INVESTORS
157 THE PRESENT ECONOMIC CRISES Most economic indicators show that, at the turn of the new century,the U.S. economy was flourishing. Despite significant challenges, suchas the September 2001 terror attack on America, the economy grew.For the first eight and one half years, the unemployment rates werelow, generally staying below six percent. RGDP growth was positivethrough 2007, and consumer prices held relatively steady during thesame period. Between the beginning of 2003 and late into 2007, theDow Jones Industrial Average generally increased, reaching a peak ofover 14,000 in October of Thus, the economy during the first sevenor so years of the twenty-first century may be described as healthy.
158 inthe fall of 2008 that most Americans, and the world, learned that anasset bubble had burst and the general economy would pay a price.1 Themacroeconomic response was predictable: RGDP growth rates turnednegative in 2008 and Expectedly, unemployment increasedsteadily beginning in April of 2008, reached over ten percent in Octoberof 2009 and held close to ten percent for many months. The Dow JonesIndustrial Average fell from its October 2007 high of over 14,000 to justunder 6500 in March 2009: well over half of the index average had beenlost. Between October 2007 and October 2008, eight trillion dollars inwealth was lost in the stock market.2 The U.S. plunged into a severeRecession.THE HOUSING BUBBLEHouse prices rosefar in excess of inflation. In some states, prices were rising, on average,over 25 percent a year (Hawaii, Arizona). In other states, house priceinflation was much more modest, rising at most seven percent onaverage (Texas)
159 As home prices fell and mortgage borrowers had increasing difficulty paying their loans, the vulnerability of banks was exposed. There were267 bank failures between the turn of the century and June 1, 2010,and 88 percent of these were after the beginning of 2008.THE CAUSE OF THE HOUSINGG BUBBLEThe narrative which follows explains how the housing bubble wascreated, how it popped, and how it led to a bank crisis in the U.S. Theunprecedented rise in home prices in the U.S. was the result of a mix ofpublic policy, monetary policy, and regulation. Blendedtogether, the policies and regulation led to higher home prices by:significantly increasing the demand for homes and for mortgages tofinance the home purchases; increasing the supply of mortgages, particularlyfor low-income home buyers; and restricting land use whichcreated a scarcity of attractive new home sites. Once home pricescrested and then began plummeting, the high risk nature of the mortgageswas exposed.
160 Beginning in the early 1990s, the U.S. federal government, through a series of regulatory, legislative, and policy directives, committed itself tothe expansion of homeownership. To achieve this increase in ownership, public policy relied, in part, onGovernment Sponsored Enterprises (GSEs). In particular, the FederalNational Mortgage Association (Fannie Mae) and the Federal Home LoanMortgage Corporation (Freddie Mac), both GSEs under the regulatorysupervision of the Office of the Federal Housing Enterprise Oversight(OFHEO) which, in turn, was housed in the Housing and UrbanDevelopment (HUD) agency, were required to undertake an affordablehousing mission established by Congress. As GSEs, both Fannie Mae andFreddie Mac have a unique business model. Both GSEs are owned privatelyby shareholders but operate with a public mission, under a congressionalcharter, with a line of credit at the Treasury. Consequently,the GSEs are privately owned but publically operated with the backingof the U.S. Treasury.Banks, thrifts, or mortgage companiesoriginate the mortgage loan and then turn around and sell the loans tothe GSEs.
161 Once Fannie and Freddie had purchased the mortgages they typically had two options. Either they would hold onto the mortgages and earnthe interest on them or they would package up the mortgages and sellthem off to investors. If they sold the mortgages off, this would free upfunds to purchase even more mortgages from banks. Further, the GSEsguaranteed the investors that they would pay the interest and principalon the mortgages, even if the borrower could not.6The GSEs were purchasing many different types of mortgages but,given the affordable housing mission, many of the mortgages were subprime.There is no universal definition of a subprime loan, but generallyspeaking, a subprime loan is of higher credit risk than prime loanslargely because of the risk characteristics of the borrower. Subprime borrowers,for example, may have poor credit histories, high debt burdensrelative to their income, or little money for down payment. Since a subprimeloan carries greater risk, the interest rate on these loans is higherthan on prime mortgage loans. Another category of mortgage loans,Banking and Crisis in the Twenty-First Century: 2000–known as Alt-A loans, carry risk between prime and subprime loans. TheGSEs were committed to purchasing Alt-A and subprime loans as a part oftheir support for the affordable housing policy of the federal government.
162 Concurrent with the GSEs purchasing and reselling mortgage loans, the Federal Reserve was pursuing a policy of low interest rates. FigureA.25 contains the federal funds rate from January 2000 through March2010 and shows that between the end of 2000 and the middle of 2004,interest rates fell to about one percent and held at this historically lowlevel until rising to about three percent in the middle of 2005, andfinally reaching just over five percent in the middle of 2006.Low interest rates and theresulting reduced cost of borrowing fueled the increasing demand forMortgages.State laws and federal financial and tax regulation also played animportant role in driving up home prices in the 2000s.LAND USE REGULATION: States and municipalities began, in the 1960s, passing land use restrictions.These may take several forms, from restricting how land may beused (e.g. the farmer who no longer wants to farm cannot sell the landfor development), to mandated minimum lot-sizes (e.g. a home must bebuilt on at least one acre of land), to limiting the annual number of buildingpermits.These policies and laws make land more scarce, and consequently,more expensive for home building.NONRECOURSE MORTGAGE LOANS